Ajanta Pharma Limited's (NSE:AJANTPHARM) Has Had A Decent Run On The Stock market: Are Fundamentals In The Driver's Seat?

Most readers would already know that Ajanta Pharma's (NSE:AJANTPHARM) stock increased by 7.4% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to investigate if the company's decent financials had a hand to play in the recent price move. In this article, we decided to focus on Ajanta Pharma's ROE.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. Put another way, it reveals the company's success at turning shareholder investments into profits.

Check out our latest analysis for Ajanta Pharma

How Do You Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Ajanta Pharma is:

21% = ₹6.2b ÷ ₹29b (Based on the trailing twelve months to December 2020).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each ₹1 of shareholders' capital it has, the company made ₹0.21 in profit.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

Ajanta Pharma's Earnings Growth And 21% ROE

To start with, Ajanta Pharma's ROE looks acceptable. Further, the company's ROE compares quite favorably to the industry average of 14%. However, for some reason, the higher returns aren't reflected in Ajanta Pharma's meagre five year net income growth average of 2.9%. That's a bit unexpected from a company which has such a high rate of return. Such a scenario is likely to take place when a company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

We then compared Ajanta Pharma's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 16% in the same period, which is a bit concerning.

Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Ajanta Pharma is trading on a high P/E or a low P/E, relative to its industry.

Is Ajanta Pharma Efficiently Re-investing Its Profits?

Ajanta Pharma's low three-year median payout ratio of 20% (or a retention ratio of 80%) should mean that the company is retaining most of its earnings to fuel its growth. However, the low earnings growth number doesn't reflect this as high growth usually follows high profit retention. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.

In addition, Ajanta Pharma has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 23% of its profits over the next three years. Accordingly, forecasts suggest that Ajanta Pharma's future ROE will be 21% which is again, similar to the current ROE.

Conclusion

In total, it does look like Ajanta Pharma has some positive aspects to its business. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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