Can Mixed Fundamentals Have A Negative Impact on Wesfarmers Limited (ASX:WES) Current Share Price Momentum?

Wesfarmers' (ASX:WES) stock is up by a considerable 27% over the past three months. However, we wonder if the company's inconsistent financials would have any adverse impact on the current share price momentum. Specifically, we decided to study Wesfarmers' ROE in this article.

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

View 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$2.0b ÷ AU$9.7b (Based on the trailing twelve months to December 2019).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.20 in profit.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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 20% ROE

At first glance, Wesfarmers seems to have a decent ROE. Especially when compared to the industry average of 6.6% the company's ROE looks pretty impressive. Given the circumstances, we can't help but wonder why Wesfarmers saw little to no growth in the past five years. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

Next, on comparing with the industry net income growth, we found that Wesfarmers' reported growth was lower than the industry growth of 2.4% 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. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. What is WES worth today? The intrinsic value infographic in our free research report helps visualize whether WES is currently mispriced by the market.

Is Wesfarmers Using Its Retained Earnings Effectively?

Wesfarmers' very high three-year median payout ratio of 128% suggests that the company is paying its shareholders more than what it is earning. This does go some way in explaining the negligible earnings growth seen by Wesfarmers. Paying a dividend higher than reported profits is not a sustainable move. That's a huge risk in our books.

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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 90% over the next three years. Despite the lower expected payout ratio, the company's ROE is not expected to change by much.

Summary

On the whole, we feel that the performance shown by Wesfarmers can be open to many interpretations. In spite of the high ROE, the company has failed to see growth in its earnings due to it paying out most of its profits as dividend, with almost nothing left to invest into its own business. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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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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