Will Weakness in Mount Gibson Iron Limited's (ASX:MGX) Stock Prove Temporary Given Strong Fundamentals?

It is hard to get excited after looking at Mount Gibson Iron's (ASX:MGX) recent performance, when its stock has declined 24% over the past month. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Specifically, we decided to study Mount Gibson Iron's ROE in this article.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Mount Gibson Iron

How Is ROE Calculated?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Mount Gibson Iron is:

16% = AU$114m ÷ AU$730m (Based on the trailing twelve months to December 2020).

The 'return' is the profit over the last twelve months. That means that for every A$1 worth of shareholders' equity, the company generated A$0.16 in profit.

What Has ROE Got To Do With Earnings Growth?

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

Mount Gibson Iron's Earnings Growth And 16% ROE

To start with, Mount Gibson Iron's ROE looks acceptable. Further, the company's ROE is similar to the industry average of 14%. This probably goes some way in explaining Mount Gibson Iron's significant 22% net income growth over the past five years amongst other factors. We reckon that there could also be other factors at play here. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.

Next, on comparing Mount Gibson Iron's net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 27% 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. If you're wondering about Mount Gibson Iron's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Mount Gibson Iron Using Its Retained Earnings Effectively?

The three-year median payout ratio for Mount Gibson Iron is 34%, which is moderately low. The company is retaining the remaining 66%. 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.

Moreover, Mount Gibson Iron 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 24% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 34%, over the same period.

Summary

On the whole, we feel that Mount Gibson Iron's performance has been quite good. 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. Remember, the price of a stock is also dependent on the perceived risk. Therefore investors must keep themselves informed about the risks involved before investing in any company. Our risks dashboard would have the 5 risks we have identified for Mount Gibson Iron.

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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.
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