Declining Stock and Decent Financials: Is The Market Wrong About GlaxoSmithKline Pharmaceuticals Limited (NSE:GLAXO)?

GlaxoSmithKline Pharmaceuticals (NSE:GLAXO) has had a rough month with its share price down 11%. But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. In this article, we decided to focus on GlaxoSmithKline Pharmaceuticals' 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.

View our latest analysis for GlaxoSmithKline Pharmaceuticals

How To Calculate Return On Equity?

ROE can be calculated by using the formula:

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

So, based on the above formula, the ROE for GlaxoSmithKline Pharmaceuticals is:

36% = ₹4.8b ÷ ₹13b (Based on the trailing twelve months to December 2020).

The 'return' is the yearly profit. That means that for every ₹1 worth of shareholders' equity, the company generated ₹0.36 in profit.

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. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.

GlaxoSmithKline Pharmaceuticals' Earnings Growth And 36% ROE

To begin with, GlaxoSmithKline Pharmaceuticals has a pretty high ROE which is interesting. Secondly, even when compared to the industry average of 14% the company's ROE is quite impressive. For this reason, GlaxoSmithKline Pharmaceuticals' five year net income decline of 16% raises the question as to why the high ROE didn't translate into earnings growth. So, there might be some other aspects that could explain this. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

That being said, we compared GlaxoSmithKline Pharmaceuticals' performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 16% in the same period.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 GlaxoSmithKline Pharmaceuticals is trading on a high P/E or a low P/E, relative to its industry.

Is GlaxoSmithKline Pharmaceuticals Using Its Retained Earnings Effectively?

GlaxoSmithKline Pharmaceuticals has a high three-year median payout ratio of 85% (that is, it is retaining 15% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run.

Additionally, GlaxoSmithKline Pharmaceuticals has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 67% over the next three years. Regardless, the ROE is not expected to change much for the company despite the lower expected payout ratio.

Summary

In total, it does look like GlaxoSmithKline Pharmaceuticals 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. Bear in mind, the company reinvests a small portion of its profits, which means that investors aren't reaping the benefits of the high rate of return. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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