Wesfarmers (ASX:WES) has had a great run on the share market with its stock up by a significant 16% over the last three months. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. In this article, we decided to focus on Wesfarmers' ROE.

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. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for Wesfarmers

How Do You 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:

17% = AU$1.6b ÷ AU$9.3b (Based on the trailing twelve months to June 2020).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.17 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. 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 17% ROE

At first glance, Wesfarmers seems to have a decent ROE. Further, the company's ROE compares quite favorably to the industry average of 6.6%. However, we are curious as to how the high returns still resulted in flat growth for Wesfarmers in the past five years. Therefore, there could be some other aspects that could potentially be preventing the company from growing. These include low earnings retention or poor allocation of capital.

As a next step, we compared Wesfarmers' net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 0.1%.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). This then helps them determine if the stock is placed for a bright or bleak future. Is WES fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Wesfarmers Efficiently Re-investing Its Profits?

Wesfarmers has a three-year median payout ratio as high as 108% meaning that the company is paying a dividend which is beyond its means. The absence in growth is therefore not surprising. Its usually very hard to sustain dividend payments that are higher than reported profits. This is indicative of risk.

Moreover, Wesfarmers has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. 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%. Still, forecasts suggest that Wesfarmers' future ROE will rise to 22% even though the the company's payout ratio is not expected to change by much.

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.

This article by Simply Wall St is general in nature. 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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