Declining Stock and Solid Fundamentals: Is The Market Wrong About Fortescue Metals Group Limited (ASX:FMG)?

With its stock down 8.7% over the past three months, it is easy to disregard Fortescue Metals Group (ASX:FMG). However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. Particularly, we will be paying attention to Fortescue Metals Group's ROE today.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for Fortescue Metals Group

How Do You 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:

36% = US$4.7b ÷ US$13b (Based on the trailing twelve months to June 2020).

The 'return' refers to a company's earnings over the last year. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.36.

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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.

Fortescue Metals Group's Earnings Growth And 36% ROE

Firstly, we acknowledge that Fortescue Metals Group has a significantly high ROE. Secondly, even when compared to the industry average of 13% the company's ROE is quite impressive. So, the substantial 41% net income growth seen by Fortescue Metals Group over the past five years isn't overly surprising.

As a next step, we compared Fortescue Metals Group's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 32%.

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. This then helps them determine if the stock is placed for a bright or bleak future. What is FMG worth today? The intrinsic value infographic in our free research report helps visualize whether FMG is currently mispriced by the market.

Is Fortescue Metals Group Making Efficient Use Of Its Profits?

The high three-year median payout ratio of 57% (implying that it keeps only 43% of profits) for Fortescue Metals Group suggests that the company's growth wasn't really hampered despite it returning most of the earnings to its shareholders.

Additionally, Fortescue Metals Group has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 67%. Regardless, Fortescue Metals Group's ROE is speculated to decline to 16% despite there being no anticipated change in its payout ratio.

Conclusion

In total, we are pretty happy 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. Having said that, on studying current analyst estimates, we were concerned to see that while the company has grown its earnings in the past, analysts expect its earnings to shrink 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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This article by Simply Wall St is general in nature. 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.
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