Is Fortescue Metals Group Limited's (ASX:FMG) Stock's Recent Performance Being Led By Its Attractive Financial Prospects?

Fortescue Metals Group's (ASX:FMG) stock is up by a considerable 40% over the past three months. Given the company's impressive performance, we decided to study its financial indicators more closely as a company's financial health over the long-term usually dictates market outcomes. Specifically, we decided to study Fortescue Metals Group's ROE in this article.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for Fortescue Metals Group

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 Fortescue Metals Group is:

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

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.36 in profit.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.

Fortescue Metals Group's Earnings Growth And 36% ROE

To begin with, Fortescue Metals Group has a pretty high ROE which is interesting. 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. If you're wondering about Fortescue Metals Group's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

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.

Moreover, Fortescue Metals Group is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 73% over the next three years. Accordingly, the expected increase in the payout ratio explains the expected decline in the company's ROE to 22%, over the same period.

Summary

Overall, we are quite pleased with Fortescue Metals Group's performance. Especially the high ROE, Which has contributed to the impressive growth seen in earnings. Despite the company reinvesting only a small portion of its profits, it still has managed to grow its earnings so that is appreciable. That being so, according to the latest industry analyst forecasts, the company's earnings are expected to shrink in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

When trading Fortescue Metals Group or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.