Wesfarmers Limited's (ASX:WES) Stock Is Going Strong: Is the Market Following Fundamentals?

Most readers would already be aware that Wesfarmers' (ASX:WES) stock increased significantly by 8.5% over the past month. Since the market usually pay for a company’s long-term fundamentals, we decided to study the company’s key performance indicators to see if they could be influencing the market. Specifically, we decided to study Wesfarmers' ROE in this article.

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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for Wesfarmers

How Is ROE Calculated?

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:

30% = AU$2.6b ÷ AU$8.6b (Based on the trailing twelve months to June 2024).

The 'return' refers to a company's earnings over the last year. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.30.

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 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 30% ROE

First thing first, we like that Wesfarmers has an impressive ROE. Second, a comparison with the average ROE reported by the industry of 7.9% also doesn't go unnoticed by us. Probably as a result of this, Wesfarmers was able to see a decent net income growth of 7.6% over the last five years.

Next, on comparing Wesfarmers' net income growth with the industry, we found that the company's reported growth is similar to the industry average growth rate of 7.6% over the last few years.

Earnings growth is a huge factor in stock valuation. 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. If you're wondering about Wesfarmers''s valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

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. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 87%. As a result, Wesfarmers' ROE is not expected to change by much either, which we inferred from the analyst estimate of 34% for future ROE.

Summary

On the whole, we feel that Wesfarmers' performance has been quite good. We are particularly impressed by the considerable earnings growth posted by the company, which was likely backed by its high ROE. While the company is paying out most of its earnings as dividends, it has been able to grow its earnings in spite of it, so that's probably a good sign. The latest industry analyst forecasts show that the company is expected to maintain 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.