Did you know there are some financial metrics that can provide clues of a potential multi-bagger? One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing amount of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. Although, when we looked at Woolworths Group (ASX:WOW), it didn't seem to tick all of these boxes.
Understanding 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 Woolworths Group, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.14 = AU$3.5b ÷ (AU$39b - AU$13b) (Based on the trailing twelve months to January 2021).
So, Woolworths Group has an ROCE of 14%. That's a pretty standard return and it's in line with the industry average of 14%.
In the above chart we have measured Woolworths Group'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 Woolworths Group.
What The Trend Of ROCE Can Tell Us
On the surface, the trend of ROCE at Woolworths Group doesn't inspire confidence. Over the last five years, returns on capital have decreased to 14% from 23% five years ago. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It may take some time before the company starts to see any change in earnings from these investments.
What We Can Learn From Woolworths Group's ROCE
Bringing it all together, while we're somewhat encouraged by Woolworths Group's reinvestment in its own business, we're aware that returns are shrinking. Yet to long term shareholders the stock has gifted them an incredible 123% return in the last five years, so the market appears to be rosy about its future. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.
On a separate note, we've found 2 warning signs for Woolworths Group you'll probably want to know about.
While Woolworths Group isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.
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