Forterra (LON:FORT) has had a rough month with its share price down 9.3%. However, the company’s fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Particularly, we will be paying attention to Forterra’s ROE today.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
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 Forterra is:
25% = UK£58m ÷ UK£231m (Based on the trailing twelve months to June 2022).
The ‘return’ is the yearly profit. One way to conceptualize this is that for each £1 of shareholders’ capital it has, the company made £0.25 in profit.
What Is The Relationship Between ROE And Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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.
Forterra’s Earnings Growth And 25% ROE
First thing first, we like that Forterra has an impressive ROE. Second, a comparison with the average ROE reported by the industry of 13% also doesn’t go unnoticed by us. For this reason, Forterra’s five year net income decline of 8.3% raises the question as to why the high ROE didn’t translate into earnings growth. Based on this, we feel that there might be other reasons which haven’t been discussed so far in this article that could be hampering the company’s growth. These include low earnings retention or poor allocation of capital.
However, when we compared Forterra’s growth with the industry we found that while the company’s earnings have been shrinking, the industry has seen an earnings growth of 8.1% in the same period. This is quite worrisome.
Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. 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 Forterra is trading on a high P/E or a low P/E, relative to its industry.
Is Forterra Making Efficient Use Of Its Profits?
Looking at its three-year median payout ratio of 36% (or a retention ratio of 64%) which is pretty normal, Forterra’s declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. So there might be other factors at play here which could potentially be hampering growth. For example, the business has faced some headwinds.
In addition, Forterra has been paying dividends over a period of six years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline. Looking at the current analyst consensus data, we can see that the company’s future payout ratio is expected to rise to 57% over the next three years. Despite the higher expected payout ratio, the company’s ROE is not expected to change by much.
On the whole, we do feel that Forterra has some positive attributes. However, given the high ROE and high profit retention, we would expect the company to be delivering strong earnings growth, but that isn’t the case here. This suggests that there might be some external threat to the business, that’s hampering its 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.
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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.
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