Fortescue Metals Group Limited (ASX:FMG) outperformed the Steel industry on the basis of its ROE – producing a higher 15.84% relative to the peer average of 11.68% over the past 12 months. While the impressive ratio tells us that FMG has made significant profits from little equity capital, ROE doesn’t tell us if FMG has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether FMG’s ROE is actually sustainable. View our latest analysis for Fortescue Metals Group
What you must know about ROE
Return on Equity (ROE) weighs Fortescue Metals Group’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Fortescue Metals Group, which is 11.17%. This means Fortescue Metals Group returns enough to cover its own cost of equity, with a buffer of 4.66%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
Dupont Formula
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Fortescue Metals Group can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Fortescue Metals Group currently has. Currently the debt-to-equity ratio stands at a low 42.67%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Fortescue Metals Group’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.