Compass Group PLC's (LON:CPG) Stock Going Strong But Fundamentals Look Weak: What Implications Could This Have On The Stock?

Compass Group's (LON:CPG) stock is up by a considerable 19% over the past three months. We, however wanted to have a closer look at its key financial indicators as the markets usually pay for long-term fundamentals, and in this case, they don't look very promising. In this article, we decided to focus on Compass Group's ROE.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for Compass Group

How Is ROE Calculated?

ROE 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 Compass Group is:

2.8% = UK£135m ÷ UK£4.8b (Based on the trailing twelve months to September 2020).

The 'return' is the profit over the last twelve months. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.03.

What Is The Relationship Between ROE And Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Based on how much of its profits the company chooses to reinvest or "retain", we are then able to evaluate a company's future ability to generate profits. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

A Side By Side comparison of Compass Group's Earnings Growth And 2.8% ROE

It is quite clear that Compass Group's ROE is rather low. Even compared to the average industry ROE of 5.2%, the company's ROE is quite dismal. Given the circumstances, the significant decline in net income by 3.4% seen by Compass Group over the last five years is not surprising. We reckon that there could also be other factors at play here. Such as - low earnings retention or poor allocation of capital.

So, as a next step, we compared Compass Group's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 5.1% in the same period.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. If you're wondering about Compass Group's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Compass Group Using Its Retained Earnings Effectively?

While the company did payout a portion of its dividend in the past, it currently doesn't pay a dividend. This implies that potentially all of its profits are being reinvested in the business.

Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 56%. However, Compass Group's ROE is predicted to rise to 22% despite there being no anticipated change in its payout ratio.

Conclusion

In total, we would have a hard think before deciding on any investment action concerning Compass Group. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. 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 latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

When trading Compass Group or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

This article by Simply Wall St is general in nature. 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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

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