Is Formosa Petrochemical Corporation's (TWSE:6505) Stock On A Downtrend As A Result Of Its Poor Financials?

Formosa Petrochemical (TWSE:6505) has had a rough three months with its share price down 8.2%. Given that stock prices are usually driven by a company’s fundamentals over the long term, which in this case look pretty weak, we decided to study the company's key financial indicators. In this article, we decided to focus on Formosa Petrochemical's ROE.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Formosa Petrochemical

How Is ROE Calculated?

The formula for ROE is:

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

So, based on the above formula, the ROE for Formosa Petrochemical is:

6.4% = NT$22b ÷ NT$341b (Based on the trailing twelve months to December 2023).

The 'return' is the yearly profit. One way to conceptualize this is that for each NT$1 of shareholders' capital it has, the company made NT$0.06 in profit.

What Is The Relationship Between ROE And 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. 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.

Formosa Petrochemical's Earnings Growth And 6.4% ROE

When you first look at it, Formosa Petrochemical's ROE doesn't look that attractive. A quick further study shows that the company's ROE doesn't compare favorably to the industry average of 13% either. Therefore, it might not be wrong to say that the five year net income decline of 16% seen by Formosa Petrochemical was probably the result of it having a lower ROE. However, there could also be other factors causing the earnings to decline. For example, it is possible that the business has allocated capital poorly or that the company has a very high payout ratio.

That being said, we compared Formosa Petrochemical's 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 22% in the same 5-year period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. Is 6505 fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Formosa Petrochemical Making Efficient Use Of Its Profits?

Formosa Petrochemical's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 75% (or a retention ratio of 25%). With only very little left to reinvest into the business, growth in earnings is far from likely.

In addition, Formosa Petrochemical 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 79% of its profits over the next three years. Still, forecasts suggest that Formosa Petrochemical's future ROE will rise to 12% even though the the company's payout ratio is not expected to change by much.

Summary

Overall, we would be extremely cautious before making any decision on Formosa Petrochemical. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. 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 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.