It is hard to get excited after looking at Wesfarmers' (ASX:WES) recent performance, when its stock has declined 8.0% over the past month. 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.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for Wesfarmers

How Is ROE Calculated?

ROE 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:

29% = AU$2.4b ÷ AU$8.0b (Based on the trailing twelve months to June 2022).

The 'return' is the income the business earned over the last year. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.29 in profit.

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. 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 29% ROE

First thing first, we like that Wesfarmers has an impressive ROE. Additionally, the company's ROE is higher compared to the industry average of 19% which is quite remarkable. However, for some reason, the higher returns aren't reflected in Wesfarmers' meagre five year net income growth average of 2.2%. This is generally not the case as when a company has a high rate of return it should usually also have a high earnings growth rate. We reckon that a low growth, when returns are quite high could be the result of certain circumstances like low earnings retention or or poor allocation of capital.

Next, on comparing with the industry net income growth, we found that Wesfarmers' growth is quite high when compared to the industry average growth of 0.3% in the same period, which is great to see.

Earnings growth is a huge factor in stock valuation. 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.