If you're looking for a multi-bagger, there's a few things to keep an eye out for. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing 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. Having said that, while the ROCE is currently high for REA Group (ASX:REA), we aren't jumping out of our chairs because returns are decreasing.
Return On Capital Employed (ROCE): What is it?
For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. The formula for this calculation on REA Group is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.31 = AU$414m ÷ (AU$1.7b - AU$415m) (Based on the trailing twelve months to December 2020).
Thus, REA Group has an ROCE of 31%. That's a fantastic return and not only that, it outpaces the average of 11% earned by companies in a similar industry.
In the above chart we have measured REA 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 REA Group.
What The Trend Of ROCE Can Tell Us
When we looked at the ROCE trend at REA Group, we didn't gain much confidence. To be more specific, while the ROCE is still high, it's fallen from 45% where it was five years ago. However it looks like REA Group 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.
On a side note, REA Group's current liabilities have increased over the last five years to 24% of total assets, effectively distorting the ROCE to some degree. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. While the ratio isn't currently too high, it's worth keeping an eye on this because if it gets particularly high, the business could then face some new elements of risk.
The Bottom Line On REA Group's ROCE
Bringing it all together, while we're somewhat encouraged by REA Group's reinvestment in its own business, we're aware that returns are shrinking. Investors must think there's better things to come because the stock has knocked it out of the park, delivering a 183% gain to shareholders who have held over the last five years. But if the trajectory of these underlying trends continue, we think the likelihood of it being a multi-bagger from here isn't high.
If you'd like to know about the risks facing REA Group, we've discovered 2 warning signs that you should be aware of.
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