Fortescue Metals Group's's (ASX:FMG) stock is up by a...

Fortescue Metals Group's's (ASX:FMG) stock is up by a considerable 20% over the past three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. Specifically, we decided to study Fortescue Metals Group'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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Fortescue Metals Group

How To Calculate Return On Equity?

ROE 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 Fortescue Metals Group is:

40% = US$5.0b ÷ US$13b (Based on the trailing twelve months to December 2019).

The 'return' is the yearly profit. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.40.

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. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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.

Fortescue Metals Group's Earnings Growth And 40% ROE

Firstly, we acknowledge that Fortescue Metals Group has a significantly high ROE. Additionally, the company's ROE is higher compared to the industry average of 11% which is quite remarkable. Under the circumstances, Fortescue Metals Group's considerable five year net income growth of 33% was to be expected.

Next, on comparing Fortescue Metals Group's net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 38% in the same period.

ASX:FMG Past Earnings Growth May 19th 2020

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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. Is FMG fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Fortescue Metals Group Efficiently Re-investing Its Profits?

The three-year median payout ratio for Fortescue Metals Group is 38%, which is moderately low. The company is retaining the remaining 62%. So it seems that Fortescue Metals Group is reinvesting efficiently in a way that it sees impressive growth in its earnings (discussed above) and pays a dividend that's well covered.

Moreover, Fortescue Metals Group is determined to keep sharing its profits with shareholders which we infer from its long history of nine years of paying a dividend. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to rise to 62% over the next three years. Therefore, the expected rise in the payout ratio explains why the company's ROE is expected to decline to 13% over the same period.

https://finance.yahoo.com/news/fortescue-metals-group-limiteds-asx-001103041.html