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It is hard to get excited after looking at Fortescue Metals Group's (ASX:FMG) recent performance, when its stock has declined 7.7% over the past three months. But if you pay close attention, you might gather that its strong financials could mean that the stock could potentially see an increase in value in the long-term, given how markets usually reward companies with good financial health. In this article, we decided to focus on Fortescue Metals Group's ROE.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
Check out our latest analysis for Fortescue Metals Group
How To 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 Metals Group is:
36% = US$4.7b ÷ US$13b (Based on the trailing twelve months to June 2020).
The 'return' is the profit over the last twelve months. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.36.
Why Is ROE Important For 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.
A Side By Side comparison of Fortescue Metals Group's Earnings Growth And 36% ROE
First thing first, we like that Fortescue Metals Group has an impressive ROE. Secondly, even when compared to the industry average of 13% the company's ROE is quite impressive. So, the substantial 41% net income growth seen by Fortescue Metals Group over the past five years isn't overly surprising.
Next, on comparing with the industry net income growth, we found that Fortescue Metals Group's growth is quite high when compared to the industry average growth of 32% in the same period, which is great to see.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. 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 Fortescue Metals Group is trading on a high P/E or a low P/E, relative to its industry.