Could The Market Be Wrong About Fortescue Metals Group Limited (ASX:FMG) Given Its Attractive Financial Prospects?

It is hard to get excited after looking at Fortescue Metals Group's (ASX:FMG) recent performance, when its stock has declined 6.4% over the past three months. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Particularly, we will be paying attention to Fortescue Metals Group's ROE today.

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for Fortescue Metals Group

How To Calculate Return On Equity?

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 Fortescue Metals Group is:

27% = US$4.8b ÷ US$18b (Based on the trailing twelve months to June 2023).

The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.27 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. 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.

A Side By Side comparison of Fortescue Metals Group's Earnings Growth And 27% ROE

To begin with, Fortescue Metals Group has a pretty high ROE which is interesting. Secondly, even when compared to the industry average of 10% the company's ROE is quite impressive. Under the circumstances, Fortescue Metals Group's considerable five year net income growth of 22% was to be expected.

As a next step, we compared Fortescue Metals Group's net income growth with the industry and found that the company has a similar growth figure when compared with the industry average growth rate of 25% in the same period.

Earnings growth is an important metric to consider when valuing a stock. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). 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 Fortescue Metals Group is trading on a high P/E or a low P/E, relative to its industry.

Is Fortescue Metals Group Making Efficient Use Of Its Profits?

Fortescue Metals Group has a significant three-year median payout ratio of 75%, meaning the company only retains 25% of its income. This implies that the company has been able to achieve high earnings growth despite returning most of its profits to shareholders.

Besides, Fortescue Metals Group has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 52% over the next three years. Regardless, the future ROE for Fortescue Metals Group is predicted to decline to 15% despite the anticipated decrease in the payout ratio. We reckon that there could probably be other factors that could be driving the forseen decline in the company's ROE.

Conclusion

Overall, we are quite pleased with Fortescue Metals Group's performance. In particular, its high ROE is quite noteworthy and also the probable explanation behind its considerable earnings growth. Yet, the company is retaining a small portion of its profits. Which means that the company has been able to grow its earnings in spite of it, so that's not too bad. With that said, on studying the latest analyst forecasts, we found that while the company has seen growth in its past earnings, analysts expect its future earnings to shrink. 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.