Costa Group Holdings Limited's (ASX:CGC) Stock Going Strong But Fundamentals Look Weak: What Implications Could This Have On The Stock?

Costa Group Holdings (ASX:CGC) has had a great run on the share market with its stock up by a significant 7.5% over the last week. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimately dictates market outcomes. Particularly, we will be paying attention to Costa Group Holdings' ROE today.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for Costa Group Holdings

How Is ROE Calculated?

Return on equity 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 Costa Group Holdings is:

5.8% = AU$47m ÷ AU$816m (Based on the trailing twelve months to January 2023).

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$0.06 in profit.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. 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.

Costa Group Holdings' Earnings Growth And 5.8% ROE

On the face of it, Costa Group Holdings' ROE is not much to talk about. However, its ROE is similar to the industry average of 7.0%, so we won't completely dismiss the company. Having said that, Costa Group Holdings' five year net income decline rate was 18%. Remember, the company's ROE is a bit low to begin with. Therefore, the decline in earnings could also be the result of this.

That being said, we compared Costa Group Holdings' performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 10% in the same period.

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. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is Costa Group Holdings fairly valued compared to other companies? These 3 valuation measures might help you decide.

Is Costa Group Holdings Efficiently Re-investing Its Profits?

Costa Group Holdings' 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 87% (or a retention ratio of 13%). The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run. You can see the 2 risks we have identified for Costa Group Holdings by visiting our risks dashboard for free on our platform here.

Moreover, Costa Group Holdings has been paying dividends for seven years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer consistent dividends even though earnings have been shrinking. Our latest analyst data shows that the future payout ratio of the company is expected to drop to 57% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 10%, over the same period.

Summary

On the whole, Costa Group Holdings' performance is quite a big let-down. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. 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 latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.