Is Weakness In CVS Group plc (LON:CVSG) Stock A Sign That The Market Could be Wrong Given Its Strong Financial Prospects?

With its stock down 19% over the past three months, it is easy to disregard CVS Group (LON:CVSG). However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Specifically, we decided to study CVS Group's ROE in this article.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for CVS Group

How Is ROE Calculated?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for CVS Group is:

10% = UK£26m ÷ UK£261m (Based on the trailing twelve months to June 2024).

The 'return' is the profit 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 £0.10 in profit.

What Is The Relationship Between ROE And Earnings Growth?

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

A Side By Side comparison of CVS Group's Earnings Growth And 10% ROE

To start with, CVS Group's ROE looks acceptable. Further, the company's ROE is similar to the industry average of 10%. This certainly adds some context to CVS Group's exceptional 31% net income growth seen over the past five years. However, there could also be other drivers behind this growth. For example, it is possible that the company's management has made some good strategic decisions, or that the company has a low payout ratio.

We then performed a comparison between CVS Group's net income growth with the industry, which revealed that the company's growth is similar to the average industry growth of 31% in the same 5-year period.

Earnings growth is a huge factor in stock valuation. 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. 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 CVS Group is trading on a high P/E or a low P/E, relative to its industry.

Is CVS Group Using Its Retained Earnings Effectively?

CVS Group has a really low three-year median payout ratio of 18%, meaning that it has the remaining 82% left over to reinvest into its business. So it looks like CVS Group is reinvesting profits heavily to grow its business, which shows in its earnings growth.

Additionally, CVS 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. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 9.2% over the next three years. As a result, the expected drop in CVS Group's payout ratio explains the anticipated rise in the company's future ROE to 15%, over the same period.

Summary

Overall, we are quite pleased with CVS Group's performance. Particularly, we like that the company is reinvesting heavily into its business, and at a high rate of return. Unsurprisingly, this has led to an impressive earnings growth. That being so, a study of the latest analyst forecasts show that the company is expected to see a slowdown in its future earnings growth. 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.