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Has Wesfarmers Limited (ASX:WES) Stock's Recent Performance Got Anything to Do With Its Financial Health?

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Most readers would already know that Wesfarmers' (ASX:WES) stock increased by 8.2% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to investigate if the company's decent financials had a hand to play in the recent price move. Specifically, we decided to study Wesfarmers' ROE in this article.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Wesfarmers

How Do You Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Wesfarmers is:

20% = AU$1.9b ÷ AU$9.6b (Based on the trailing twelve months to December 2020).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.20 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. 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.

Wesfarmers' Earnings Growth And 20% ROE

At first glance, Wesfarmers seems to have a decent ROE. Especially when compared to the industry average of 7.7% the company's ROE looks pretty impressive. Probably as a result of this, Wesfarmers was able to see a decent growth of 6.4% over the last five years.

When you consider the fact that the industry earnings have shrunk at a rate of 1.0% in the same period, the company's net income growth is pretty remarkable.

past-earnings-growth
past-earnings-growth

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. If you're wondering about Wesfarmers''s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Wesfarmers Using Its Retained Earnings Effectively?

Wesfarmers' high three-year median payout ratio of 105% suggests that the company is paying out more to its shareholders than what it is making. In spite of this, the company was able to grow its earnings respectably, as we saw above. It would still be worth keeping an eye on that high payout ratio, if for some reason the company runs into problems and business deteriorates.

Additionally, Wesfarmers 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. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 88%. Still, forecasts suggest that Wesfarmers' future ROE will rise to 25% even though the the company's payout ratio is not expected to change by much.

Summary

In total, it does look like Wesfarmers has some positive aspects to its business. Namely, its high earnings growth, which was likely due to its high ROE. However, investors could have benefitted even more from the high ROE, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining hardly any of its profits. The latest industry analyst forecasts show that the company is expected to maintain its current growth rate. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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.

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

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