Yahoo Finance Should Weakness in Compass Group PLC's (LON:CPG) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?
It is hard to get excited after looking at Compass Group's (LON:CPG) recent performance, when its stock has declined 2.7% over the past three months. However, the company's fundamentals look pretty decent, and long-term financials are usually aligned with future market price movements. In this article, we decided to focus on Compass Group's ROE.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
See our latest analysis for Compass Group
How To 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 Compass Group is:
14% = UK£737m ÷ UK£5.4b (Based on the trailing twelve months to March 2022).
The 'return' is the income the business earned over the last year. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.14 in profit.
Why Is ROE Important For Earnings Growth?
So far, we've learned that ROE is a measure of a company's profitability. 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 all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.
Compass Group's Earnings Growth And 14% ROE
To begin with, Compass Group seems to have a respectable ROE. And on comparing with the industry, we found that the the average industry ROE is similar at 13%. However, while Compass Group has a pretty respectable ROE, its five year net income decline rate was 28% . Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. These include low earnings retention or poor allocation of capital.
As a next step, we compared Compass Group's performance with the industry and found thatCompass Group's performance is depressing even when compared with the industry, which has shrunk its earnings at a rate of 11% in the same period, which is a slower than the company.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. Is CPG fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Compass Group Using Its Retained Earnings Effectively?
Compass Group's declining earnings is not surprising given how the company is spending most of its profits in paying dividends, judging by its three-year median payout ratio of 54% (or a retention ratio of 46%). With only very little left to reinvest into the business, growth in earnings is far from likely.
Moreover, Compass Group 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 50%. However, Compass Group's ROE is predicted to rise to 26% despite there being no anticipated change in its payout ratio.
Summary
On the whole, we do feel that Compass Group has some positive attributes. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE. Bear in mind, the company reinvests a small portion of its profits, which means that investors aren't reaping the benefits of the high rate of return. With that said, we studied the latest analyst forecasts and found that while the company has shrunk its earnings in the past, analysts expect its earnings to grow in the future. To know more about the company's future earnings growth forecasts take a look at this free report 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.
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