Has Fortescue Ltd's (ASX:FMG) Impressive Stock Performance Got Anything to Do With Its Fundamentals?

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Fortescue's (ASX:FMG) stock is up by a considerable 19% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. Particularly, we will be paying attention to Fortescue'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. Put another way, it reveals the company's success at turning shareholder investments into profits.

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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 is:

20% = US$3.9b ÷ US$19b (Based on the trailing twelve months to December 2024).

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$0.20 in profit.

View our latest analysis for Fortescue

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. 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

A Side By Side comparison of Fortescue's Earnings Growth And 20% ROE

To start with, Fortescue's ROE looks acceptable. On comparing with the average industry ROE of 11% the company's ROE looks pretty remarkable. Needless to say, we are quite surprised to see that Fortescue's net income shrunk at a rate of 5.4% over the past five years. We reckon that there could be some other factors at play here that are preventing the company's growth. These include low earnings retention or poor allocation of capital.

However, when we compared Fortescue's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 19% in the same period. This is quite worrisome.

Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. If you're wondering about Fortescue's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Fortescue Efficiently Re-investing Its Profits?

With a high three-year median payout ratio of 72% (implying that 28% of the profits are retained), most of Fortescue's profits are being paid to shareholders, which explains the company's shrinking earnings. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run. To know the 2 risks we have identified for Fortescue visit our risks dashboard for free.

Additionally, Fortescue has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 56% over the next three years. Regardless, the future ROE for Fortescue is predicted to decline to 10% 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

On the whole, we do feel that Fortescue has some positive attributes. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return. Investors could have benefitted from the high ROE, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining a small portion of its profits. Moreover, after studying current analyst estimates, we discovered that the company's earnings are expected to continue 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. 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.