Latrobe Magnesium's (ASX:LMG) stock is up by a considerable 30% over the past three months. Given that the market rewards strong financials in the long-term, we wonder if that is the case in this instance. Particularly, we will be paying attention to Latrobe Magnesium'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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for Latrobe Magnesium

How To 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 Latrobe Magnesium is:

51% = AU$6.0m ÷ AU$12m (Based on the trailing twelve months to June 2020).

The 'return' is the income the business earned over the last year. That means that for every A$1 worth of shareholders' equity, the company generated A$0.51 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 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.

Latrobe Magnesium's Earnings Growth And 51% ROE

Firstly, we acknowledge that Latrobe Magnesium has a significantly high ROE. Second, a comparison with the average ROE reported by the industry of 12% also doesn't go unnoticed by us. As a result, Latrobe Magnesium's exceptional 24% net income growth seen over the past five years, doesn't come as a surprise.

Next, on comparing with the industry net income growth, we found that Latrobe Magnesium's reported growth was lower than the industry growth of 34% in the same period, which is not something we like to see.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. If you're wondering about Latrobe Magnesium's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Latrobe Magnesium Using Its Retained Earnings Effectively?

Latrobe Magnesium doesn't pay any dividend currently which essentially means that it has been reinvesting all of its profits into the business. This definitely contributes to the high earnings growth number that we discussed above.

Conclusion

In total, we are pretty happy with Latrobe Magnesium's performance. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. As a result, the decent growth in its earnings is not surprising. 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. Not to forget, share price outcomes are also dependent on the potential risks a company may face. So it is important for investors to be aware of the risks involved in the business. Our risks dashboard would have the 3 risks we have identified for Latrobe Magnesium.

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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