Divi's Laboratories Limited (NSE:DIVISLAB) Stock Is Going Strong But Fundamentals Look Uncertain: What Lies Ahead ?

Divi's Laboratories' (NSE:DIVISLAB) stock is up by a considerable 23% over the past three months. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. In this article, we decided to focus on Divi's Laboratories' ROE.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for Divi's Laboratories

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 Divi's Laboratories is:

12% = ₹17b ÷ ₹136b (Based on the trailing twelve months to June 2024).

The 'return' is the amount earned after tax over the last twelve months. So, this means that for every ₹1 of its shareholder's investments, the company generates a profit of ₹0.12.

What Has ROE Got To Do With 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. Assuming all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

Divi's Laboratories' Earnings Growth And 12% ROE

On the face of it, Divi's Laboratories' ROE is not much to talk about. Yet, a closer study shows that the company's ROE is similar to the industry average of 13%. We can see that Divi's Laboratories has grown at a five year net income growth average rate of 3.8%, which is a bit on the lower side. Bear in mind, the company's ROE is not very high . So this could also be one of the reasons behind the company's low growth in earnings.

We then compared Divi's Laboratories' net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 20% in the same 5-year period, which is a bit concerning.

Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. 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 Divi's Laboratories is trading on a high P/E or a low P/E, relative to its industry.

Is Divi's Laboratories Making Efficient Use Of Its Profits?

While Divi's Laboratories has a decent three-year median payout ratio of 44% (or a retention ratio of 56%), it has seen very little growth in earnings. So there could be some other explanation in that regard. For instance, the company's business may be deteriorating.

In addition, Divi's Laboratories 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's future payout ratio is expected to drop to 33% over the next three years. The fact that the company's ROE is expected to rise to 17% over the same period is explained by the drop in the payout ratio.

Summary

Overall, we have mixed feelings about Divi's Laboratories. While the company does have a high rate of profit retention, its low rate of return is probably hampering its earnings growth. 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 latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.