Weak Financial Prospects Seem To Be Dragging Down Compass Group PLC (LON:CPG) Stock

With its stock down 2.7% over the past three months, it is easy to disregard Compass Group (LON:CPG). We decided to study the company's financials to determine if the downtrend will continue as the long-term performance of a company usually dictates market outcomes. In this article, we decided to focus on Compass Group's ROE.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Compass Group

How Do You 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:

7.3% = UK£357m ÷ UK£4.9b (Based on the trailing twelve months to September 2021).

The 'return' is the income the business earned over the last year. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.07 in profit.

Why Is ROE Important For Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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. 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 7.3% ROE

When you first look at it, Compass Group's ROE doesn't look that attractive. However, its ROE is similar to the industry average of 8.7%, so we won't completely dismiss the company. But Compass Group saw a five year net income decline of 27% over the past five years. Bear in mind, the company does have a slightly low ROE. Therefore, the decline in earnings could also be the result of this.

Furthermore, even when compared to the industry, which has been shrinking its earnings at a rate 21% in the same period, we found that Compass Group's performance is pretty disappointing, as it suggests that the company has been shrunk its earnings at a rate faster than the industry.

Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. 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?

With a high three-year median payout ratio of 52% (implying that 48% of the profits are retained), most of Compass Group's profits are being paid to shareholders, which explains the company's shrinking earnings. The business is only left with a small pool of capital to reinvest - A vicious cycle that doesn't benefit the company in the long-run.

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 48%. Still, forecasts suggest that Compass Group's future ROE will rise to 23% even though the the company's payout ratio is not expected to change by much.

Conclusion

On the whole, Compass Group's performance is quite a big let-down. As a result of its low ROE and lack of much reinvestment into the business, the company has seen a disappointing earnings growth rate. 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.

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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.