If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base 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. However, after investigating Nestlé (VTX:NESN), we don't think it's current trends fit the mold of a multi-bagger.
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. To calculate this metric for Nestlé, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.17 = CHF15b ÷ (CHF124b - CHF40b) (Based on the trailing twelve months to December 2020).
Thus, Nestlé has an ROCE of 17%. On its own, that's a standard return, however it's much better than the 7.6% generated by the Food industry.
In the above chart we have measured Nestlé's prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.
The Trend Of ROCE
Over the past five years, Nestlé's ROCE and capital employed have both remained mostly flat. This tells us the company isn't reinvesting in itself, so it's plausible that it's past the growth phase. So unless we see a substantial change at Nestlé in terms of ROCE and additional investments being made, we wouldn't hold our breath on it being a multi-bagger. That being the case, it makes sense that Nestlé has been paying out 61% of its earnings to its shareholders. If the company is in fact lacking growth opportunities, that's one of the viable alternatives for the money.
Our Take On Nestlé's ROCE
In a nutshell, Nestlé has been trudging along with the same returns from the same amount of capital over the last five years. Although the market must be expecting these trends to improve because the stock has gained 84% over the last five years. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.
One more thing to note, we've identified 1 warning sign with Nestlé and understanding this should be part of your investment process.
If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive 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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