Formosa Chemicals & Fibre Corporation's (TPE:1326) Has Been On A Rise But Financial Prospects Look Weak: Is The Stock Overpriced?

Most readers would already be aware that Formosa Chemicals & Fibre's (TPE:1326) stock increased significantly by 13% over the past three months. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimatley dictates market outcomes. Specifically, we decided to study Formosa Chemicals & Fibre'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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Formosa Chemicals & Fibre

How To Calculate Return On Equity?

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 Formosa Chemicals & Fibre is:

4.3% = NT$15b ÷ NT$346b (Based on the trailing twelve months to September 2020).

The 'return' refers to a company's earnings over the last year. So, this means that for every NT$1 of its shareholder's investments, the company generates a profit of NT$0.04.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. 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.

Formosa Chemicals & Fibre's Earnings Growth And 4.3% ROE

On the face of it, Formosa Chemicals & Fibre's ROE is not much to talk about. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 7.7%. Therefore, it might not be wrong to say that the five year net income decline of 6.5% seen by Formosa Chemicals & Fibre was probably the result of it having a lower ROE. We reckon that there could also be other factors at play here. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

So, as a next step, we compared Formosa Chemicals & Fibre's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 1.0% in the same period.

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 Formosa Chemicals & Fibre's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Formosa Chemicals & Fibre Using Its Retained Earnings Effectively?

Formosa Chemicals & Fibre has a high three-year median payout ratio of 78% (that is, it is retaining 22% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. With only very little left to reinvest into the business, growth in earnings is far from likely. You can see the 2 risks we have identified for Formosa Chemicals & Fibre by visiting our risks dashboard for free on our platform here.

Additionally, Formosa Chemicals & Fibre 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. 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 74%. Still, forecasts suggest that Formosa Chemicals & Fibre's future ROE will rise to 6.3% even though the the company's payout ratio is not expected to change by much.

Summary

On the whole, Formosa Chemicals & Fibre's performance is quite a big let-down. Because the company is not reinvesting much into the business, and given the low ROE, it's not surprising to see the lack or absence of growth in its earnings. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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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.
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