Is Fortescue Metals Group Limited (ASX:FMG) Investing Effectively In Its Business?

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Today we’ll evaluate Fortescue Metals Group Limited (ASX:FMG) to determine whether it could have potential as an investment idea. In particular, we’ll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

First up, we’ll look at what ROCE is and how we calculate it. Next, we’ll compare it to others in its industry. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. In brief, it is a useful tool, but it is not without drawbacks. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.’

How Do You Calculate Return On Capital Employed?

The formula for calculating the return on capital employed is:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)

Or for Fortescue Metals Group:

0.11 = US$1.8b ÷ (US$18b – US$1.2b) (Based on the trailing twelve months to June 2018.)

Therefore, Fortescue Metals Group has an ROCE of 11%.

See our latest analysis for Fortescue Metals Group

Does Fortescue Metals Group Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. Using our data, Fortescue Metals Group’s ROCE appears to be around the 12% average of the Metals and Mining industry. Separate from Fortescue Metals Group’s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

In our analysis, Fortescue Metals Group’s ROCE appears to be 11%, compared to 3 years ago, when its ROCE was 4.9%. This makes us wonder if the company is improving.

ASX:FMG Last Perf February 11th 19
ASX:FMG Last Perf February 11th 19

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is only a point-in-time measure. We note Fortescue Metals Group could be considered a cyclical business. Since the future is so important for investors, you should check out our free report on analyst forecasts for Fortescue Metals Group.

Do Fortescue Metals Group’s Current Liabilities Skew Its ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Fortescue Metals Group has total assets of US$18b and current liabilities of US$1.2b. Therefore its current liabilities are equivalent to approximately 6.9% of its total assets. With low current liabilities, Fortescue Metals Group’s decent ROCE looks that much more respectable.

The Bottom Line On Fortescue Metals Group’s ROCE

If it is able to keep this up, Fortescue Metals Group could be attractive. But note: Fortescue Metals Group may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

I will like Fortescue Metals Group better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.