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Fresnillo (LON:FRES) has had a great run on the share market with its stock up by a significant 8.3% over the last month. But the company's key financial indicators appear to be differing across the board and that makes us question whether or not the company's current share price momentum can be maintained. In this article, we decided to focus on Fresnillo's ROE.
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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How To Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Fresnillo is:
12% = US$438m ÷ US$3.8b (Based on the trailing twelve months to December 2021).
The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.12 in profit.
Why Is ROE Important For Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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.
Fresnillo's Earnings Growth And 12% ROE
To begin with, Fresnillo seems to have a respectable ROE. Be that as it may, the company's ROE is still quite lower than the industry average of 15%. Needless to say, the 5.9% net income shrink rate seen by Fresnilloover the past five years is a huge dampener. Not to forget, the company does have a high ROE to begin with, just that it is lower than the industry average. Hence there might be some other aspects that are causing earnings to shrink. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.
So, as a next step, we compared Fresnillo'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 19% in the same period.
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). Doing so will help them establish if the stock's future looks promising or ominous. 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 Fresnillo is trading on a high P/E or a low P/E, relative to its industry.
Is Fresnillo Using Its Retained Earnings Effectively?
With a high three-year median payout ratio of 53% (implying that 47% of the profits are retained), most of Fresnillo's profits are being paid to shareholders, which explains the company's shrinking earnings. With only a little being reinvested into the business, earnings growth would obviously be low or non-existent.
In addition, Fresnillo has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business 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 55%. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 12%.
In total, we're a bit ambivalent about Fresnillo's performance. Specifically, the low earnings growth is a bit concerning, especially given that the company has a respectable rate of return. Investors may have benefitted, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining a small portion of its profits. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.