Returns On Capital Signal Tricky Times Ahead For Compass Group (LON:CPG)

If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. In light of that, when we looked at Compass Group (LON:CPG) and its ROCE trend, we weren't exactly thrilled.

Understanding Return On Capital Employed (ROCE)

For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. Analysts use this formula to calculate it for Compass Group:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.056 = UK£570m ÷ (UK£15b - UK£4.5b) (Based on the trailing twelve months to September 2020).

Therefore, Compass Group has an ROCE of 5.6%. On its own that's a low return on capital but it's in line with the industry's average returns of 5.5%.

Check out our latest analysis for Compass Group

In the above chart we have measured Compass Group's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Compass Group here for free.

So How Is Compass Group's ROCE Trending?

Unfortunately, the trend isn't great with ROCE falling from 25% five years ago, while capital employed has grown 103%. Usually this isn't ideal, but given Compass Group conducted a capital raising before their most recent earnings announcement, that would've likely contributed, at least partially, to the increased capital employed figure. Compass Group probably hasn't received a full year of earnings yet from the new funds it raised, so these figures should be taken with a grain of salt.

On a side note, Compass Group has done well to pay down its current liabilities to 31% of total assets. So we could link some of this to the decrease in ROCE. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.

In Conclusion...

In summary, we're somewhat concerned by Compass Group's diminishing returns on increasing amounts of capital. In spite of that, the stock has delivered a 32% return to shareholders who held over the last five years. Either way, we aren't huge fans of the current trends and so with that we think you might find better investments elsewhere.

If you want to continue researching Compass Group, you might be interested to know about the 4 warning signs that our analysis has discovered.

If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive returns on equity.

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