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Compass Group shares are worthy of their premium valuation

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Sky-high inflation and a slowing world economy mean that margin growth has become increasingly elusive this year. Indeed, many firms have struggled to pass higher input costs onto consumers at a time when discretionary incomes are falling.

However, FTSE100 catering company Compass Group [LON:CPG] has generated improving profitability over recent months. In its latest quarterly update, for example, the firm reported a 40-basis point rise in its underlying operating margin so that it reached 6.2%. It expects to be earning an underlying operating margin of around 7% by the end of the financial year. More details on its financial performance will be included in full-year results that are set to be released on 21st November.

High inflation has also benefitted the firm’s top line over recent months. Rising costs across a variety of industries have prompted many companies to seek efficiencies, with the outsourcing of catering being a common theme. Therefore, a continuation of the current high inflation environment, which is widely expected to persist over the medium term, could act as a catalyst on Compass’ share price performance.

Compass Group an improving long-term outlook

Of course, the company has benefitted from a gradual reopening of the world economy as Covid-induced restrictions have eased. Its top line amounted to 109% of corresponding 2019 sales in the third quarter, with the firm’s organic revenue growing by 43% year-on-year. This represented an acceleration from the 38% growth rate recorded in the first half of the year and led to an increase in full-year sales growth guidance. It now expects full-year organic revenue growth to reach 35%, which is a significant increase on the 20% to 25% figure stated at the time of its first-quarter results.

Alongside organic growth, Compass Group is taking advantage of lower global asset prices to make acquisitions. It spent GBP223m buying other businesses in the first three quarters of the year as it seeks to improve its competitive advantage through growing digital innovation.

Its financial position means it has further capacity to make acquisitions over the coming months. In the first half of the year, the company’s operating profit covered net finance costs 17x. Meanwhile, its net debt-to-equity ratio of 47% confirms it can afford to take on more debt to engage in additional M&A activity.

An uncertain short-term future

While Covid-19 now appears unlikely to significantly harm the firm’s financial prospects, a slowing world economy could weigh on Compass’ profitability and share price return. And, with its shares trading on a forward price-to-earnings ratio of 29, they do not currently offer a wide margin of safety when compared to numerous cheap FTSE 100 stocks.

Compass Group opened trading today (16th November) at 1,841.5p. The company has offered a 11.5% year-to-date return, a 20.4% one-year return with its shares ranging from 1,435p to 1,970.5p over a 52-week period. The company has a market capitalization of GBP32.5bn.

The firm’s growth potential means it is worthy of a premium stock market valuation. Its capacity to not only cope with rampant inflation, but benefit from it, is a relatively scarce attribute at the moment and could become increasingly desirable among investors. Moreover, its solid financial position, growing profitability and scope for M&A activity mean it is well placed to deliver further share price growth following its 17% gain over the past year.

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This article does not constitute investment advice. Do your own research or consult a professional advisor.

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