Compass Group PLC's (LON:CPG) Has Had A Decent Run On The Stock market: Are Fundamentals In The Driver's Seat?

Compass Group's (LON:CPG) stock up by 1.6% over the past month. As most would know, long-term fundamentals have a strong correlation with market price movements, so we decided to look at the company's key financial indicators today to determine if they have any role to play in the recent price movement. Particularly, we will be paying attention to Compass Group's ROE today.

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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for Compass Group

How Do You 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:

19% = UK£1.1b ÷ UK£5.9b (Based on the trailing twelve months to September 2022).

The 'return' refers to a company's earnings over the last year. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.19.

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 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 19% ROE

At first glance, Compass Group seems to have a decent ROE. Especially when compared to the industry average of 8.7% the company's ROE looks pretty impressive. Needless to say, we are quite surprised to see that Compass Group's net income shrunk at a rate of 21% over the past five years. 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.

Next, when we compared with the industry, which has shrunk its earnings at a rate of 6.5% in the same period, we still found Compass Group's performance to be quite bleak, because the company has been shrinking its earnings faster than the industry.

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. 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 Making Efficient Use Of Its Profits?

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 56% (or a retention ratio of 44%). With only a little being reinvested into the business, earnings growth would obviously be low or non-existent.

Additionally, Compass Group has paid dividends over a period of at least ten years, which means that the company's management is determined to pay dividends even if it means little to no earnings growth. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 50% of its profits over the next three years. Regardless, the future ROE for Compass Group is predicted to rise to 25% despite there being not much change expected in its payout ratio.

Summary

In total, it does look like Compass Group has some positive aspects to its business. Yet, the low earnings growth is a bit concerning, especially given that the company has a high rate of return. Investors could have benefitted from the high ROE, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining a small portion of its profits. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. 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.