There are a few key trends to look for if we want to identify the next multi-bagger. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. So while Smartgroup (ASX:SIQ) has a high ROCE right now, lets see what we can decipher from how returns are changing.
What is Return On Capital Employed (ROCE)?
If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. To calculate this metric for Smartgroup, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.21 = AU$82m ÷ (AU$488m - AU$107m) (Based on the trailing twelve months to June 2020).
Thus, Smartgroup has an ROCE of 21%. That's a fantastic return and not only that, it outpaces the average of 17% earned by companies in a similar industry.
View our latest analysis for Smartgroup
In the above chart we have measured Smartgroup's prior ROCE against its prior performance, but the future is arguably more important. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Smartgroup.
The Trend Of ROCE
When we looked at the ROCE trend at Smartgroup, we didn't gain much confidence. Historically returns on capital were even higher at 28%, but they have dropped over the last five years. However it looks like Smartgroup might be reinvesting for long term growth because while capital employed has increased, the company's sales haven't changed much in the last 12 months. It may take some time before the company starts to see any change in earnings from these investments.
In Conclusion...
To conclude, we've found that Smartgroup is reinvesting in the business, but returns have been falling. Although the market must be expecting these trends to improve because the stock has gained 67% over the last five years. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.
One more thing to note, we've identified 1 warning sign with Smartgroup and understanding it should be part of your investment process.
Smartgroup is not the only stock earning high returns. If you'd like to see more, check out our free list of companies earning high returns on equity with solid fundamentals.
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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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About ASX:SIQ
Very undervalued with solid track record and pays a dividend.
