Nick Scali (ASX:NCK) Could Be Struggling To Allocate Capital

There are a few key trends to look for if we want to identify the next multi-bagger. In a perfect world, we'd like to see a company investing more capital into its business and ideally the returns earned from that capital are also increasing. 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 Nick Scali (ASX:NCK), we aren't jumping out of our chairs because returns are decreasing.

Understanding Return On Capital Employed (ROCE)

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. The formula for this calculation on Nick Scali is:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.31 = AU$88m ÷ (AU$408m - AU$120m) (Based on the trailing twelve months to December 2020).

So, Nick Scali has an ROCE of 31%. That's a fantastic return and not only that, it outpaces the average of 19% earned by companies in a similar industry.

Check out our latest analysis for Nick Scali

In the above chart we have measured Nick Scali'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 Nick Scali.

What Can We Tell From Nick Scali's ROCE Trend?

On the surface, the trend of ROCE at Nick Scali doesn't inspire confidence. To be more specific, while the ROCE is still high, it's fallen from 40% where it was five years ago. 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. If these investments prove successful, this can bode very well for long term stock performance.

The Key Takeaway

In summary, despite lower returns in the short term, we're encouraged to see that Nick Scali is reinvesting for growth and has higher sales as a result. And the stock has done incredibly well with a 213% return over the last five years, so long term investors are no doubt ecstatic with that result. So while the underlying trends could already be accounted for by investors, we still think this stock is worth looking into further.

If you'd like to know more about Nick Scali, we've spotted 2 warning signs, and 1 of them is a bit unpleasant.

High returns are a key ingredient to strong performance, so check out our free list ofstocks earning high returns on equity with solid balance sheets.

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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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