It is hard to get excited after looking at Mount Gibson Iron's (ASX:MGX) recent performance, when its stock has declined 8.3% over the past week. However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. Specifically, we decided to study Mount Gibson Iron's ROE in this article.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

Check out our latest analysis for Mount Gibson Iron

How Do You 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 Mount Gibson Iron is:

16% = AU$114m ÷ AU$730m (Based on the trailing twelve months to December 2020).

The 'return' is the amount earned after tax 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$0.16.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 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.

Mount Gibson Iron's Earnings Growth And 16% ROE

To begin with, Mount Gibson Iron seems to have a respectable ROE. Even when compared to the industry average of 15% the company's ROE looks quite decent. Consequently, this likely laid the ground for the impressive net income growth of 22% seen over the past five years by Mount Gibson Iron. We believe that there might also be other aspects that are positively influencing the company's earnings growth. Such as – high earnings retention or an efficient management in place.

As a next step, we compared Mount Gibson Iron's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 28% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. 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 Mount Gibson Iron is trading on a high P/E or a low P/E, relative to its industry.

Is Mount Gibson Iron Efficiently Re-investing Its Profits?

The three-year median payout ratio for Mount Gibson Iron is 34%, which is moderately low. The company is retaining the remaining 66%. By the looks of it, the dividend is well covered and Mount Gibson Iron is reinvesting its profits efficiently as evidenced by its exceptional growth which we discussed above.

Additionally, Mount Gibson Iron has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 21% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 25%, over the same period.

Conclusion

On the whole, we feel that Mount Gibson Iron's performance has been quite good. Specifically, we like that the company is reinvesting a huge chunk of its profits at a high rate of return. This of course has caused the company to see a good amount of growth in its earnings. If the company continues to grow its earnings the way it has, that could have a positive impact on its share price given how earnings per share influence long-term share prices. Remember, the price of a stock is also dependent on the perceived risk. Therefore investors must keep themselves informed about the risks involved before investing in any company. To know the 4 risks we have identified for Mount Gibson Iron visit our risks dashboard for free.

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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