It is hard to get excited after looking at Wesfarmers’ (ASX:WES) recent performance, when its stock has declined 8.0% over the past month. However, stock prices are usually driven by a company’s financials over the long term, which in this case look pretty respectable. In this article, we decided to focus on Wesfarmers’ ROE.
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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How Is ROE Calculated?
ROE 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 Wesfarmers is:
29% = AU$2.4b ÷ AU$8.0b (Based on the trailing twelve months to June 2022).
The ‘return’ is the income the business earned over the last year. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.29 in profit.
What Has ROE Got To Do With Earnings Growth?
We have already established that ROE serves as an efficient profit-generating gauge for a company’s future earnings. 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 everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don’t necessarily bear these characteristics.
Wesfarmers’ Earnings Growth And 29% ROE
First thing first, we like that Wesfarmers has an impressive ROE. Additionally, the company’s ROE is higher compared to the industry average of 19% which is quite remarkable. However, for some reason, the higher returns aren’t reflected in Wesfarmers’ meagre five year net income growth average of 2.2%. This is generally not the case as when a company has a high rate of return it should usually also have a high earnings growth rate. We reckon that a low growth, when returns are quite high could be the result of certain circumstances like low earnings retention or or poor allocation of capital.
Next, on comparing with the industry net income growth, we found that Wesfarmers’ growth is quite high when compared to the industry average growth of 0.3% in the same period, which is great to see.
Earnings growth is a huge factor in stock valuation. 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. Is WES fairly valued? This infographic on the company’s intrinsic value has everything you need to know.
Is Wesfarmers Using Its Retained Earnings Effectively?
Wesfarmers has a three-year median payout ratio of 91% (implying that it keeps only 9.0% of its profits), meaning that it pays out most of its profits to shareholders as dividends, and as a result, the company has seen low earnings growth.
Additionally, Wesfarmers has paid dividends over a period of at least ten years, which means that the company’s management is determined to pay dividends even if it means little to no earnings growth. Upon studying the latest analysts’ consensus data, we found that the company is expected to keep paying out approximately 85% of its profits over the next three years. Therefore, the company’s future ROE is also not expected to change by much with analysts predicting an ROE of 31%.
On the whole, we do feel that Wesfarmers has some positive attributes. Specifically, its high ROE which likely led to the growth in earnings. Bear in mind, the company reinvests little to none of its profits, which means that investors aren’t necessarily reaping the full benefits of the high rate of return. Having said that, looking at the current analyst estimates, we found that the company’s earnings are expected to gain momentum. 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.
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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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