Sun Pharmaceutical Industries (NSE:SUNPHARMA) has had a great run on the share market with its stock up by a significant 18% over the last 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 Sun Pharmaceutical Industries' 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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How Is ROE Calculated?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Sun Pharmaceutical Industries is:
12% = ₹65b ÷ ₹525b (Based on the trailing twelve months to December 2021).
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 ₹0.12 in profit.
What Is The Relationship Between ROE And Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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.
Sun Pharmaceutical Industries' Earnings Growth And 12% ROE
When you first look at it, Sun Pharmaceutical Industries' ROE doesn't look that attractive. Yet, a closer study shows that the company's ROE is similar to the industry average of 14%. However, Sun Pharmaceutical Industries has seen a flattish net income growth over the past five years, which is not saying much. Remember, the company's ROE is not particularly great to begin with. Hence, this provides some context to the flat earnings growth seen by the company.
We then compared Sun Pharmaceutical Industries' net income growth with the industry and found that the average industry growth rate was 22% in the same period.
Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. 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 Sun Pharmaceutical Industries is trading on a high P/E or a low P/E, relative to its industry.
Is Sun Pharmaceutical Industries Using Its Retained Earnings Effectively?
In spite of a normal three-year median payout ratio of 34% (or a retention ratio of 66%), Sun Pharmaceutical Industries hasn't seen much growth in its earnings. Therefore, there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.
Moreover, Sun Pharmaceutical Industries has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 18% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 15%, over the same period.
On the whole, we feel that the performance shown by Sun Pharmaceutical Industries can be open to many interpretations. 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. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. 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. 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.