What trends should we look for it we want to identify stocks that can multiply in value over the long term? Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, 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. In light of that, when we looked at Energy World (ASX:EWC) and its ROCE trend, we weren't exactly thrilled.
Understanding Return On Capital Employed (ROCE)
For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. The formula for this calculation on Energy World is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.025 = US$39m ÷ (US$1.7b - US$180m) (Based on the trailing twelve months to June 2020).
Therefore, Energy World has an ROCE of 2.5%. On its own that's a low return on capital but it's in line with the industry's average returns of 2.5%.
Historical performance is a great place to start when researching a stock so above you can see the gauge for Energy World's ROCE against it's prior returns. If you'd like to look at how Energy World has performed in the past in other metrics, you can view this free graph of past earnings, revenue and cash flow.
The Trend Of ROCE
On the surface, the trend of ROCE at Energy World doesn't inspire confidence. To be more specific, ROCE has fallen from 5.2% over the last five years. 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's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.
On a side note, Energy World has done well to pay down its current liabilities to 11% of total assets. That could partly explain why the ROCE has dropped. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.
The Key Takeaway
In summary, Energy World is reinvesting funds back into the business for growth but unfortunately it looks like sales haven't increased much just yet. And investors appear hesitant that the trends will pick up because the stock has fallen 41% in the last five years. On the whole, we aren't too inspired by the underlying trends and we think there may be better chances of finding a multi-bagger elsewhere.
Energy World does have some risks, we noticed 4 warning signs (and 2 which are significant) we think you should know about.
While Energy World may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.
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