Most readers would already be aware that Wesfarmers' (ASX:WES) stock increased significantly by 11% over the past three months. As most would know, fundamentals are what usually guide market price movements over the long-term, 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. 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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

Check out our latest analysis for Wesfarmers

How To 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:

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

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$0.30 in profit.

What Is The Relationship Between ROE And Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. 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 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.

A Side By Side comparison of Wesfarmers' Earnings Growth And 30% ROE

First thing first, we like that Wesfarmers has an impressive ROE. Secondly, even when compared to the industry average of 12% the company's ROE is quite impressive. This likely paved the way for the modest 9.2% net income growth seen by Wesfarmers 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. past-earnings-growth

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). 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.

Moreover, Wesfarmers is determined to keep sharing its profits with shareholders which we infer from its long history of paying a dividend for at least ten years. 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%.

Conclusion

Overall, we feel that Wesfarmers certainly does have some positive factors to consider. The company has grown its earnings moderately as previously discussed. 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 quite low. With that said, the latest industry analyst forecasts reveal that the company's earnings growth is expected to slow down. To know more about the company's future earnings growth forecasts take a look at this freereport 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.