Is Weakness In Wesfarmers Limited (ASX:WES) Stock A Sign That The Market Could be Wrong Given Its Strong Financial Prospects?

It is hard to get excited after looking at Wesfarmers' (ASX:WES) recent performance, when its stock has declined 5.2% over the past month. 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. In this article, we decided to focus on Wesfarmers' ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for Wesfarmers

How Is ROE Calculated?

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 Wesfarmers is:

31% = AU$2.5b ÷ AU$8.1b (Based on the trailing twelve months to December 2022).

The 'return' is the yearly profit. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.31.

What Is The Relationship Between ROE And 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.

A Side By Side comparison of Wesfarmers' Earnings Growth And 31% ROE

To begin with, Wesfarmers has a pretty high ROE which is interesting. Secondly, even when compared to the industry average of 18% the company's ROE is quite impressive. This probably laid the groundwork for Wesfarmers' moderate 8.5% net income growth seen over the past five years.

We then compared Wesfarmers' net income growth with the industry and we're pleased to see that the company's growth figure is higher when compared with the industry which has a growth rate of 4.0% in the same period.

past-earnings-growth

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). This then helps them determine if the stock is placed for a bright or bleak future. Is WES fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Wesfarmers Making Efficient Use Of Its Profits?

While Wesfarmers has a three-year median payout ratio of 87% (which means it retains 13% of profits), the company has still seen a fair bit of earnings growth in the past, meaning that its high payout ratio hasn't hampered its ability to grow.

Besides, Wesfarmers has been paying dividends for at least ten years or more. This shows that the company is committed to sharing profits with its shareholders. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 87%. Accordingly, forecasts suggest that Wesfarmers' future ROE will be 33% which is again, similar to the current ROE.

Summary

In total, we are pretty happy with Wesfarmers' performance. In particular, its high ROE is quite noteworthy and also the probable explanation behind its considerable earnings growth. Yet, the company is retaining a small portion of its profits. Which means that the company has been able to grow its earnings in spite of it, so that's not too bad. The latest industry analyst forecasts show that the company is expected to maintain its current growth rate. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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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