Wesfarmers Limited's (ASX:WES) Has Had A Decent Run On The Stock market: Are Fundamentals In The Driver's Seat?

Most readers would already know that Wesfarmers' (ASX:WES) stock increased by 2.8% over the past three months. As most would know, long-term fundamentals have a strong correlation with market price movements, so we decided to look at the company's key financial indicators today to determine if they have any role to play in the recent price movement. Specifically, we decided to study Wesfarmers' ROE in this article.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for Wesfarmers

How To 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:

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

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$0.31 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. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. 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

Firstly, we acknowledge that Wesfarmers has a significantly high ROE. Secondly, even when compared to the industry average of 17% the company's ROE is quite impressive. Probably as a result of this, Wesfarmers was able to see a decent net income growth of 8.5% over the last five years.

We then compared Wesfarmers' net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 14% in the same period, which is a bit concerning.

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. Doing so will help them establish if the stock's future looks promising or ominous. 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 Efficiently Re-investing 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.

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. 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%. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 34%.

Summary

On the whole, we do feel that Wesfarmers has some positive attributes. Its earnings have grown respectably as we saw earlier, which was likely due to the company reinvesting its earnings at a pretty high rate of return. However, given the high ROE, we do think that the company is reinvesting a small portion of its profits. This could likely be preventing the company from growing to its full extent. We also studied the latest analyst forecasts and found that the company's earnings growth is expected be similar to 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.

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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.