Most readers would already be aware that Mount Gibson Iron's (ASX:MGX) stock increased significantly by 28% 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. In this article, we decided to focus on Mount Gibson Iron's ROE.
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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How Is ROE Calculated?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Mount Gibson Iron is:
13% = AU$84m ÷ AU$671m (Based on the trailing twelve months to June 2020).
The 'return' is the yearly profit. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.13 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. 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. 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.
Mount Gibson Iron's Earnings Growth And 13% ROE
To start with, Mount Gibson Iron's ROE looks acceptable. Even when compared to the industry average of 13% the company's ROE looks quite decent. This certainly adds some context to Mount Gibson Iron's exceptional 65% net income growth seen over the past five years. We believe that there might also be other aspects that are positively influencing the company's earnings growth. For instance, the company has a low payout ratio or is being managed efficiently.
We then compared Mount Gibson Iron's net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 32% in the same period.
Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Mount Gibson Iron is trading on a high P/E or a low P/E, relative to its industry.
Is Mount Gibson Iron Efficiently Re-investing Its Profits?
The three-year median payout ratio for Mount Gibson Iron is 37%, which is moderately low. The company is retaining the remaining 63%. By the looks of it, the dividend is well covered and Mount Gibson Iron is reinvesting its profits efficiently as evidenced by its exceptional growth which we discussed above.
Besides, Mount Gibson Iron has been paying dividends over a period of nine years. This shows that the company is committed to sharing profits with its shareholders. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 33%. However, Mount Gibson Iron's ROE is predicted to rise to 18% despite there being no anticipated change in its payout ratio.
In total, we are pretty happy with Mount Gibson Iron's performance. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see substantial growth in its earnings. If the company continues to grow its earnings the way it has, that could have a positive impact on its share price given how earnings per share influence long-term share prices. Not to forget, share price outcomes are also dependent on the potential risks a company may face. So it is important for investors to be aware of the risks involved in the business. Our risks dashboard would have the 3 risks we have identified for Mount Gibson Iron.
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