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Declining Stock and Decent Financials: Is The Market Wrong About Wesfarmers Limited (ASX:WES)?

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With its stock down 17% over the past three months, it is easy to disregard Wesfarmers (ASX:WES). However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. Particularly, we will be paying attention to Wesfarmers' ROE today.

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 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 return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Wesfarmers is:

28% = AU$2.2b ÷ AU$7.7b (Based on the trailing twelve months to December 2021).

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$0.28 in profit.

What Is The Relationship Between ROE And Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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 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 28% ROE

Firstly, we acknowledge that Wesfarmers has a significantly high ROE. Additionally, the company's ROE is higher compared to the industry average of 20% which is quite remarkable. This probably laid the groundwork for Wesfarmers' moderate 5.2% net income growth seen over the past five years.

Given that the industry shrunk its earnings at a rate of 3.7% in the same period, the net income growth of the company is quite impressive.

past-earnings-growth
past-earnings-growth

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 Using Its Retained Earnings Effectively?

The high three-year median payout ratio of 96% (or a retention ratio of 4.4%) for Wesfarmers suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

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. 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 86%. Therefore, the company's future ROE is also not expected to change by much with analysts predicting an ROE of 31%.

Summary

On the whole, we do feel that Wesfarmers has some positive attributes. 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 are expected to accelerate. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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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