Is Compass Group PLC's (LON:CPG) Recent Stock Performance Influenced By Its Fundamentals In Any Way?

Compass Group's (LON:CPG) stock is up by a considerable 14% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. Specifically, we decided to study Compass Group's ROE in this article.

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.

Check out 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:

27% = US$1.8b ÷ US$6.5b (Based on the trailing twelve months to March 2024).

The 'return' is the income the business earned over the last year. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.27.

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. 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. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

Compass Group's Earnings Growth And 27% ROE

Firstly, we acknowledge that Compass Group has a significantly high ROE. Additionally, the company's ROE is higher compared to the industry average of 8.4% which is quite remarkable. This probably laid the groundwork for Compass Group's moderate 11% net income growth seen over the past five years.

As a next step, we compared Compass Group's net income growth with the industry and were disappointed to see that the company's growth is lower than the industry average growth of 18% in the same period.

Earnings growth is an important metric to consider when valuing a stock. 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. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Compass Group is trading on a high P/E or a low P/E, relative to its industry.

Is Compass Group Efficiently Re-investing Its Profits?

The high three-year median payout ratio of 57% (or a retention ratio of 43%) for Compass Group suggests that the company's growth wasn't really hampered despite it returning most of its income to its shareholders.

Additionally, Compass Group has paid dividends over a period of at least ten years which means that the company is pretty serious about sharing its profits with shareholders. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 50%. As a result, Compass Group's ROE is not expected to change by much either, which we inferred from the analyst estimate of 31% for future ROE.

Conclusion

On the whole, we do feel that Compass Group has some positive attributes. Its earnings have grown respectably as we saw earlier, which was likely due to the company reinvesting its earnings at a pretty high rate of return. However, given the high ROE, we do think that the company is reinvesting a small portion of its profits. This could likely be preventing the company from growing to its full extent. On studying current analyst estimates, we found that analysts expect the company to continue its recent growth streak. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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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.