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Are Fortescue Metals Group Limited’s (ASX:FMG) High Returns Really That Great?

Simply Wall St

Today we'll look at Fortescue Metals Group Limited (ASX:FMG) and reflect on its potential as an investment. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

Firstly, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.

Return On Capital Employed (ROCE): What is it?

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. All else being equal, a better business will have a higher ROCE. Overall, it is a valuable metric that has its flaws. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.

So, How Do We Calculate ROCE?

Analysts use this formula to calculate return on capital employed:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

Or for Fortescue Metals Group:

0.38 = US$7.2b ÷ (US$21b - US$2.4b) (Based on the trailing twelve months to December 2019.)

So, Fortescue Metals Group has an ROCE of 38%.

See our latest analysis for Fortescue Metals Group

Is Fortescue Metals Group's ROCE Good?

One way to assess ROCE is to compare similar companies. Using our data, we find that Fortescue Metals Group's ROCE is meaningfully better than the 8.9% average in the Metals and Mining industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Setting aside the comparison to its industry for a moment, Fortescue Metals Group's ROCE in absolute terms currently looks quite high.

In our analysis, Fortescue Metals Group's ROCE appears to be 38%, compared to 3 years ago, when its ROCE was 19%. This makes us think about whether the company has been reinvesting shrewdly. The image below shows how Fortescue Metals Group's ROCE compares to its industry, and you can click it to see more detail on its past growth.

ASX:FMG Past Revenue and Net Income, February 20th 2020

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Given the industry it operates in, Fortescue Metals Group could be considered cyclical. Since the future is so important for investors, you should check out our free report on analyst forecasts for Fortescue Metals Group.

What Are Current Liabilities, And How Do They Affect Fortescue Metals Group's ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Fortescue Metals Group has total assets of US$21b and current liabilities of US$2.4b. As a result, its current liabilities are equal to approximately 11% of its total assets. A minimal amount of current liabilities limits the impact on ROCE.

What We Can Learn From Fortescue Metals Group's ROCE

, Fortescue Metals Group looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.

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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.