2 ways I analyse Wesfarmers Ltd shares

I analyse Wesfarmers Ltd (ASX:WES) shares by looking at the segment report first.

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When it comes to Wesfarmers Ltd (ASX: WES) shares, the first thing I analyse is the segment report. Then profit margins.

What is a Segment report?

Under International Financial Reporting Standards (IFRS), every public company must disclose its 'operating' segments, products and services, as well as the geographical areas in which it operates. I will go so far to say that the segment report is the single most useful disclosure for analysts, particularly for companies like Wesfarmers which have multiple businesses under one roof.

You can find Wesfarmers' segment information on page 33 of its latest half-year financial report.

It looks like this:

Source: Wesfarmers half year report

Now, you don't have to be an accounting wunderkind to understand this table.

Basically, at the top, we have the names of the 'segments', or in Wesfarmers' case, the businesses it operates. Revenue is listed below that.

From the table, we can make a pie chart to get the 'complete picture' of how and where Wesfarmers draws its revenue.

Wesfarmers sales
Data source: Wesfarmers Half Year Report

For example, we can see that Coles was the major revenue generator for the company in the first half of 2016, with $20,056 million of sales — down slightly from $20,058 million in the same period a year earlier.   

Below revenue, we have EBITDA, which is basically the 'profit of a business' with depreciation and amortisation, interest and taxes added back.

If that's confusing, don't worry, you're not the only one.

The next 'line item' is depreciation and amortisation. I won't get bogged down in the detail here but it's basically the cost of the big assets (think: freezers, cash registers, trucks, etc.) attributable to that year.

Finally, we have 'Segment EBIT' — sometimes called 'Segment Result'.

Wesfarmers profit
Data source: Wesfarmers Half Year Report

You probably guessed that this is profit (also known as 'earnings') with interest charges and tax added back.

Why do we exclude interest and tax?

Well, much of the time it gets in our way. What's more, many of these costs are incurred at the 'company level' not the individual business level. For example, in the far right columns of the segment report, you can see that the 'consolidated' (aka Wesfarmers) has costs like finance ($149 million) and income tax ($703 million) taken out of the total of the individual business' results. It would be the same as if you owned two businesses in one company, you might only list the taxes and finance costs at the company level.

This takes us to profit margins.

#2 – profit margins

If you divide the EBIT result by the revenue, you get the company's profit margin. For example, from the segment report, you can take Coles' EBIT of $902 million and divide it by sales of $20,056 million, which equals about 4.5%.

What does that tell us?

By itself, not that much.

However, we can compare the margin to that of its rivals, like Woolworths Limited (ASX: WOW) or foreign competitors like Costco. You could also compare it amongst its other businesses.

That will tell you which business is most profitable. In other words, which business has the best economics. You can then ask yourself, why are the margins better?

For example, Bunnings Warehouse (aka "Home Improvement" in the Segment report above) generates EBIT margins over 10%. Why? Probably because it is the only player in the Australian home improvement market, so it has better buying power and can charge customers more for its products.

Is Coles a bad business because it has lower margins?

Not necessarily.

Coles is a volume business. It needs you and me to buy many products for it to be a viable business.

Just imagine a funnel. Sales go in the top and EBIT comes out the bottom. If you squeeze the funnel even the tiniest bit, it would have a significant impact on what comes out of the bottom. That's why so many analysts like 'wide profit margins'.

Bringing it all together

Coles is still the dominant business when it comes to Wesfarmers' sales. But Bunnings Warehouse is the real gem in the Wesfarmers operation.

But before we jump to conclusions about Wesfarmers, remember this: it's great to look at the numbers but only qualitative analysis, such as reading the annual report and listening to management's strategy, will give you any idea of what will happen next.

For example, how is Coles dealing with Aldi's cheaper products? What will Bunnings' UK rollout do to its profit margins?

You won't find that in the segment report.

Motley Fool Contributor Owen Raszkiewicz does not have a financial interest in any company mentioned. Owen welcomes and encourages your feedback. You can follow him on Twitter @OwenRask. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of Costco Wholesale. The Motley Fool Australia owns shares of Wesfarmers Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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