It is hard to get excited after looking at Fresnillo's (LON:FRES) recent performance, when its stock has declined 12% over the past three months. It seems that the market might have completely ignored the positive aspects of the company's fundamentals and decided to weigh-in more on the negative aspects. Stock prices are usually driven by a company’s financial performance over the long term, and therefore we decided to pay more attention to the company's financial performance. Specifically, we decided to study Fresnillo'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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How Do You Calculate Return On Equity?
Return on equity 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 Fresnillo is:
10% = US$376m ÷ US$3.6b (Based on the trailing twelve months to December 2020).
The 'return' is the yearly profit. That means that for every £1 worth of shareholders' equity, the company generated £0.10 in profit.
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.
Fresnillo's Earnings Growth And 10% ROE
To begin with, Fresnillo seems to have a respectable ROE. Yet, the fact that the company's ROE is lower than the industry average of 17% does temper our expectations. Moreover, Fresnillo's net income shrunk at a rate of 2.4%over the past five years. Not to forget, the company does have a high ROE to begin with, just that it is lower than the industry average. So there might be other reasons for the earnings to shrink. These include low earnings retention or poor allocation of capital.
That being said, we compared Fresnillo's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 26% in the same period.
Earnings growth is an important metric to consider when valuing a stock. 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. If you're wondering about Fresnillo's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.
Is Fresnillo Using Its Retained Earnings Effectively?
Fresnillo's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 57% (or a retention ratio of 43%). The business is only left with a small pool of capital to reinvest – A vicious cycle that doesn't benefit the company in the long-run.
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. Upon studying the latest analysts' consensus data, we found that the company's future payout ratio is expected to drop to 43% over the next three years. Despite the lower expected payout ratio, the company's ROE is not expected to change by much.
In total, we're a bit ambivalent about Fresnillo's performance. Primarily, we are disappointed to see a lack of growth in earnings even in spite of a moderate ROE. Bear in mind, the company reinvests a small portion of its profits, which explains the lack of growth. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
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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