With its stock down 13% over the past week, it is easy to disregard FutureFuel (NYSE:FF). However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. In this article, we decided to focus on FutureFuel’s ROE.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder’s equity.
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 FutureFuel is:
31% = US$113m ÷ US$370m (Based on the trailing twelve months to June 2020).
The ‘return’ is the profit over the last twelve months. That means that for every $1 worth of shareholders’ equity, the company generated $0.31 in profit.
Why Is ROE Important For Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company’s future earnings. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.
FutureFuel’s Earnings Growth And 31% ROE
Firstly, we acknowledge that FutureFuel has a significantly high ROE. Secondly, even when compared to the industry average of 10% the company’s ROE is quite impressive. Probably as a result of this, FutureFuel was able to see a decent net income growth of 8.7% over the last five years.
Next, on comparing FutureFuel’s net income growth with the industry, we found that the company’s reported growth is similar to the industry average growth rate of 8.3% in the same period.
Earnings growth is a huge factor in stock valuation. 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. 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 FutureFuel is trading on a high P/E or a low P/E, relative to its industry.
Is FutureFuel Using Its Retained Earnings Effectively?
In FutureFuel’s case, its respectable earnings growth can probably be explained by its low three-year median payout ratio of 20% (or a retention ratio of 80%), which suggests that the company is investing most of its profits to grow its business.
Besides, FutureFuel has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders.
Overall, we are quite pleased with FutureFuel’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. Let’s not forget, business risk is also one of the factors that affects the price of the stock. So this is also an important area that investors need to pay attention to before making a decision on any business. You can see the 2 risks we have identified for FutureFuel by visiting our risks dashboard for free on our platform here.
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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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