Does The Market Have A Low Tolerance For SMS Pharmaceuticals Limited's (NSE:SMSPHARMA) Mixed Fundamentals?

SMS Pharmaceuticals (NSE:SMSPHARMA) has had a rough month with its share price down 16%. It seems that the market might have completely ignored the positive aspects of the company's fundamentals and decided to weigh-in more on the negative aspects. Fundamentals usually dictate market outcomes so it makes sense to study the company's financials. Particularly, we will be paying attention to SMS Pharmaceuticals' ROE today.

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. Put another way, it reveals the company's success at turning shareholder investments into profits.

View our latest analysis for SMS Pharmaceuticals

How To 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 SMS Pharmaceuticals is:

11% = ₹570m ÷ ₹5.4b (Based on the trailing twelve months to June 2024).

The 'return' is the profit over the last twelve months. That means that for every ₹1 worth of shareholders' equity, the company generated ₹0.11 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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. 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.

SMS Pharmaceuticals' Earnings Growth And 11% ROE

On the face of it, SMS Pharmaceuticals' ROE is not much to talk about. However, its ROE is similar to the industry average of 12%, so we won't completely dismiss the company. But then again, SMS Pharmaceuticals' five year net income shrunk at a rate of 7.6%. Remember, the company's ROE is a bit low to begin with. Hence, this goes some way in explaining the shrinking earnings.

So, as a next step, we compared SMS Pharmaceuticals' performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 15% over the last few years.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is SMS Pharmaceuticals fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is SMS Pharmaceuticals Using Its Retained Earnings Effectively?

SMS Pharmaceuticals' low three-year median payout ratio of 5.4% (implying that it retains the remaining 95% of its profits) comes as a surprise when you pair it with the shrinking earnings. This typically shouldn't be the case when a company is retaining most of its earnings. So there might be other factors at play here which could potentially be hampering growth. For instance, the business has faced some headwinds.

Additionally, SMS 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.

Summary

Overall, we have mixed feelings about SMS Pharmaceuticals. Even though it appears to be retaining most of its profits, given the low ROE, investors may not be benefitting from all that reinvestment after all. The low earnings growth suggests our theory correct. Wrapping up, we would proceed with caution with this company and one way of doing that would be to look at the risk profile of the business. To know the 3 risks we have identified for SMS Pharmaceuticals visit our risks dashboard for free.

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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.