Wesfarmers (ASX:WES) has had a rough month with its share price down 12%. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How To Calculate Return On Equity?
Return on equity 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:
24% = AU$2.4b ÷ AU$9.7b (Based on the trailing twelve months to June 2021).
The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.24 in profit.
Why Is ROE Important For 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.
Wesfarmers' Earnings Growth And 24% ROE
First thing first, we like that Wesfarmers has an impressive ROE. Secondly, even when compared to the industry average of 8.0% the company's ROE is quite impressive. This likely paved the way for the modest 12% net income growth seen by Wesfarmers over the past five years. growth
Next, on comparing with the industry net income growth, we found that the growth figure reported by Wesfarmers compares quite favourably to the industry average, which shows a decline of 4.2% in the same period.
Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. Has the market priced in the future outlook for WES? You can find out in our latest intrinsic value infographic research report.
Is Wesfarmers Using Its Retained Earnings Effectively?
The really high three-year median payout ratio of 102% for Wesfarmers suggests that the company is paying its shareholders more than what it is earning. In spite of this, the company was able to grow its earnings respectably, as we saw above. That being said, the high payout ratio could be worth keeping an eye on in case the company is unable to keep up its current growth momentum.
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. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 88%. As a result, Wesfarmers' ROE is not expected to change by much either, which we inferred from the analyst estimate of 29% for future ROE.
Overall, we feel that Wesfarmers certainly does have some positive factors to consider. Especially the growth in earnings which was backed by an impressive ROE. Still, the high ROE could have been even more beneficial to investors had the company been reinvesting more of its profits. As highlighted earlier, the current reinvestment rate appears to be negligible. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. 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.
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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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