If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. Speaking of which, we noticed some great changes in ADF Group's (TSE:DRX) returns on capital, so let's have a look.
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 ADF Group is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.098 = CA$13m ÷ (CA$200m - CA$71m) (Based on the trailing twelve months to April 2021).
Therefore, ADF Group has an ROCE of 9.8%. In absolute terms, that's a low return, but it's much better than the Metals and Mining industry average of 0.04%.
Check out our latest analysis for ADF Group
While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you'd like to look at how ADF Group has performed in the past in other metrics, you can view this free graph of past earnings, revenue and cash flow.
So How Is ADF Group's ROCE Trending?
ADF Group has not disappointed with their ROCE growth. The figures show that over the last five years, ROCE has grown 225% whilst employing roughly the same amount of capital. So our take on this is that the business has increased efficiencies to generate these higher returns, all the while not needing to make any additional investments. On that front, things are looking good so it's worth exploring what management has said about growth plans going forward.
On a side note, we noticed that the improvement in ROCE appears to be partly fueled by an increase in current liabilities. Effectively this means that suppliers or short-term creditors are now funding 35% of the business, which is more than it was five years ago. Keep an eye out for future increases because when the ratio of current liabilities to total assets gets particularly high, this can introduce some new risks for the business.
The Key Takeaway
In summary, we're delighted to see that ADF Group has been able to increase efficiencies and earn higher rates of return on the same amount of capital. Astute investors may have an opportunity here because the stock has declined 38% in the last five years. So researching this company further and determining whether or not these trends will continue seems justified.
ADF Group does have some risks though, and we've spotted 1 warning sign for ADF Group that you might be interested in.
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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About TSX:DRX
ADF Group
Engages in the design and engineering of connections including industrial coatings in Canada and the United States.
Outstanding track record with flawless balance sheet.
