When close to half the companies in the United Kingdom have price-to-earnings ratios (or "P/E's") below 14x, you may consider Compass Group PLC (LON:CPG) as a stock to avoid entirely with its 27.7x P/E ratio. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.
Compass Group certainly has been doing a good job lately as its earnings growth has been positive while most other companies have been seeing their earnings go backwards. It seems that many are expecting the company to continue defying the broader market adversity, which has increased investors’ willingness to pay up for the stock. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.
Check out our latest analysis for Compass Group
Is There Enough Growth For Compass Group?
In order to justify its P/E ratio, Compass Group would need to produce outstanding growth well in excess of the market.
If we review the last year of earnings growth, the company posted a terrific increase of 20%. Pleasingly, EPS has also lifted 859% in aggregate from three years ago, thanks to the last 12 months of growth. So we can start by confirming that the company has done a great job of growing earnings over that time.
Turning to the outlook, the next three years should generate growth of 16% per year as estimated by the analysts watching the company. That's shaping up to be materially higher than the 11% per year growth forecast for the broader market.
In light of this, it's understandable that Compass Group's P/E sits above the majority of other companies. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.
The Final Word
It's argued the price-to-earnings ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.
We've established that Compass Group maintains its high P/E on the strength of its forecast growth being higher than the wider market, as expected. At this stage investors feel the potential for a deterioration in earnings isn't great enough to justify a lower P/E ratio. It's hard to see the share price falling strongly in the near future under these circumstances.
Don't forget that there may be other risks. For instance, we've identified 1 warning sign for Compass Group that you should be aware of.
If you're unsure about the strength of Compass Group's business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.
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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.
About LSE:CPG
Compass Group
Operates as a food and support services company in North America, Europe, and internationally.
Reasonable growth potential with adequate balance sheet.
