Should Weakness in Compass Group PLC's (LON:CPG) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?

Compass Group (LON:CPG) has had a rough three months with its share price down 5.4%. But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. Particularly, we will be paying attention to Compass Group's ROE today.

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.

Our analysis indicates that CPG is potentially undervalued!

How To Calculate Return On Equity?

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 Compass Group is:

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

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.19 in profit.

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. 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.

Compass Group's Earnings Growth And 19% ROE

To start with, Compass Group's ROE looks acceptable. On comparing with the average industry ROE of 13% the company's ROE looks pretty remarkable. 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. Therefore, there might be some other aspects that could explain this. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

As a next step, we compared Compass Group's performance with the industry and found thatCompass Group's performance is depressing even when compared with the industry, which has shrunk its earnings at a rate of 9.5% in the same period, which is a slower than the company.

Earnings growth is an important metric to consider when valuing a stock. 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. Is CPG fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is Compass Group Using Its Retained Earnings Effectively?

Compass Group has a high three-year median payout ratio of 56% (that is, it is retaining 44% of its profits). This suggests that the company is paying most of its profits as dividends to its shareholders. This goes some way in explaining why its earnings have been shrinking. With only very little left to reinvest into the business, growth in earnings is far from likely.

In addition, Compass Group has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Our latest analyst data shows that the future payout ratio of the company over the next three years is expected to be approximately 53%. Regardless, the future ROE for Compass Group is predicted to rise to 24% despite there being not much change expected in its payout ratio.

Conclusion

Overall, we feel that Compass Group certainly does have some positive factors to consider. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE. Bear in mind, the company reinvests a small portion of its profits, which means that investors aren't reaping the benefits of the high rate of return. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts 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.