City Service SE's (WSE:CTS) On An Uptrend But Financial Prospects Look Pretty Weak: Is The Stock Overpriced?

City Service's (WSE:CTS) stock is up by a considerable 6.5% over the past month. However, in this article, we decided to focus on its weak fundamentals, as long-term financial performance of a business is what ultimatley dictates market outcomes. Specifically, we decided to study City Service'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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

View our latest analysis for City Service

How Is ROE Calculated?

ROE 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 City Service is:

9.3% = €4.9m ÷ €53m (Based on the trailing twelve months to September 2020).

The 'return' is the profit over the last twelve months. That means that for every PLN1 worth of shareholders' equity, the company generated PLN0.09 in profit.

What Has ROE Got To Do With Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. 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.

City Service's Earnings Growth And 9.3% ROE

At first glance, City Service's ROE doesn't look very promising. Next, when compared to the average industry ROE of 13%, the company's ROE leaves us feeling even less enthusiastic. Therefore, it might not be wrong to say that the five year net income decline of 11% seen by City Service was probably the result of it having a lower ROE. We believe that there also might be other aspects that are negatively influencing the company's earnings prospects. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

However, when we compared City Service's growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 11% in the same period. This is quite worrisome.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. 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. 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 City Service is trading on a high P/E or a low P/E, relative to its industry.

Is City Service Using Its Retained Earnings Effectively?

City Service's very high three-year median payout ratio of 161% over the last three years suggests that the company is paying its shareholders more than what it is earning and this explains the company's shrinking earnings. Paying a dividend higher than reported profits is not a sustainable move. You can see the 4 risks we have identified for City Service by visiting our risks dashboard for free on our platform here.

In addition, City Service has been paying dividends over a period of five years suggesting that keeping up dividend payments is preferred by the management even though earnings have been in decline.

Conclusion

Overall, we would be extremely cautious before making any decision on City Service. Specifically, it has shown quite an unsatisfactory performance as far as earnings growth is concerned, and a poor ROE and an equally poor rate of reinvestment seem to be the reason behind this inadequate performance. So far, we've only made a quick discussion around the company's earnings growth. To gain further insights into City Service's past profit growth, check out this visualization of past earnings, revenue and cash flows.

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This article by Simply Wall St is general in nature. 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.
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