There are a few key trends to look for if we want to identify the next multi-bagger. Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. However, after briefly looking over the numbers, we don't think Western Areas (ASX:WSA) has the makings of a multi-bagger going forward, but let's have a look at why that may be.
Return On Capital Employed (ROCE): What is it?
Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. To calculate this metric for Western Areas, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.068 = AU$40m ÷ (AU$655m - AU$65m) (Based on the trailing twelve months to June 2020).
Thus, Western Areas has an ROCE of 6.8%. Ultimately, that's a low return and it under-performs the Metals and Mining industry average of 9.6%.
In the above chart we have measured Western Areas' 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 Western Areas.
What The Trend Of ROCE Can Tell Us
On the surface, the trend of ROCE at Western Areas doesn't inspire confidence. To be more specific, ROCE has fallen from 13% over the last five years. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.On a side note, Western Areas has done well to pay down its current liabilities to 9.9% of total assets. So we could link some of this to the decrease in ROCE. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.
The Bottom Line On Western Areas' ROCE
In summary, despite lower returns in the short term, we're encouraged to see that Western Areas is reinvesting for growth and has higher sales as a result. However, despite the promising trends, the stock has fallen 11% over the last five years, so there might be an opportunity here for astute investors. So we think it'd be worthwhile to look further into this stock given the trends look encouraging.
If you'd like to know about the risks facing Western Areas, we've discovered 2 warning signs that you should be aware of.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
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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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