The Wesfarmers Ltd (ASX: WES) share price has been a great performer for shareholders over the past year, surging 47%, as the chart below shows.
As the owner of Bunnings, Kmart, Officeworks, Target and Priceline, the business benefits from a resilient Australian economy.
However, that doesn't mean it's a buy at any price. Growing businesses are typically valued on a higher earnings multiple than stagnant businesses – it's how the market accounts for future profit potential.
When a share price rises faster than earnings, it leads to a more expensive valuation.
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Rising price-earnings ratio
According to Commsec, the Wesfarmers share price traded on an average annual price-earnings (P/E) ratio of 20 in FY19 (before COVID-19) and an average P/E ratio of 22 in FY23.
Currently, according to the forecast on Commsec, the Wesfarmers share price is valued at more than 32x FY24's estimated earnings.
That is a significantly higher valuation despite the fact that interest rates today are significantly higher than in FY19 and higher than in FY23.
It's not as though retail conditions are booming – plenty of people don't have much money to spend on retail at the moment, given the higher cost of living.
While the Wesfarmers earnings multiple has increased, there are a couple of things to keep in mind.
Strong performance and expectations of growth
Bunnings and Kmart are primed to perform well during this uncertain period. One of their main selling points is the value offered to households. Consumers want their money to stretch as much as possible for what they're buying.
The businesses have managed to keep delivering sales growth in recent times, enabling Bunnings and Kmart to capture market share. Increased scale gives them even greater buying power to get better prices from suppliers and unlock operating leverage.
In the first half of FY24, Bunnings sales rose 1.7%, and Kmart Group sales increased 5%. Bunnings earnings increased 0.3% to $1.28 billion, and Kmart Group earnings jumped 26.5% to $601 million.
Excitingly, Kmart is taking its Anko brand international, which could create a strong, long growth runway.
UBS forecasts that Wesfarmers could generate net profit after tax (NPAT) of $2.56 billion in FY24. By FY26, net profit could have increased by 19% to $3.06 billion. Further ahead, by FY28, net profit could reach $3.7 billion. That means in four years, the net profit could rise by 44%.
Rising profit is a useful support for the Wesfarmers share price.
Interest rate cuts getting closer
While interest rates are currently high, there are expectations rate cuts are going to come along. Perhaps within the next six months, if some media speculation is to be believed.
If interest rates are reduced, it could help the Wesfarmers share price valuation. Why? Legendary investor Warren Buffett once explained:
The value of every business, the value of a farm, the value of an apartment house, the value of any economic asset, is 100% sensitive to interest rates because all you are doing in investing is transferring some money to somebody now in exchange for what you expect the stream of money to be, to come in over a period of time, and the higher interest rates are the less that present value is going to be. So every business by its nature…its intrinsic valuation is 100% sensitive to interest rates.
So, investors may be willing to pay more for Wesfarmers shares if the interest rate is cut.
