Wesfarmers Limited's (ASX:WES) Stock Has Shown Weakness Lately But Financial Prospects Look Decent: Is The Market Wrong?

With its stock down 3.0% over the past three months, it is easy to disregard Wesfarmers (ASX:WES). 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.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for Wesfarmers

How Do You 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:

30% = AU$2.5b ÷ AU$8.3b (Based on the trailing twelve months to June 2023).

The 'return' is the amount earned after tax over the last twelve months. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.30.

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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

Wesfarmers' Earnings Growth And 30% ROE

To begin with, Wesfarmers has a pretty high ROE which is interesting. Second, a comparison with the average ROE reported by the industry of 12% also doesn't go unnoticed by us. This probably laid the groundwork for Wesfarmers' moderate 9.2% net income growth seen over the past five years.

Next, on comparing with the industry net income growth, we found that Wesfarmers' reported growth was lower than the industry growth of 15% over the last few years, 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. 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 Making Efficient Use Of Its Profits?

The high three-year median payout ratio of 87% (or a retention ratio of 13%) for Wesfarmers suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

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 88%. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 32%.

Summary

Overall, we feel that Wesfarmers certainly does have some positive factors to consider. 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. Having said that, the company's earnings growth is expected to slow down, as forecasted in the current analyst estimates. 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.