If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing 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. Looking at WashTec (ETR:WSU), it does have a high ROCE right now, but lets see how returns are trending.
Understanding Return On Capital Employed (ROCE)
If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Analysts use this formula to calculate it for WashTec:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.21 = €27m ÷ (€253m - €124m) (Based on the trailing twelve months to March 2021).
Thus, WashTec has an ROCE of 21%. In absolute terms that's a great return and it's even better than the Machinery industry average of 7.3%.
Above you can see how the current ROCE for WashTec compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like to see what analysts are forecasting going forward, you should check out our free report for WashTec.
What Can We Tell From WashTec's ROCE Trend?
In terms of WashTec's historical ROCE movements, the trend isn't fantastic. To be more specific, while the ROCE is still high, it's fallen from 37% where it was five years ago. And considering revenue has dropped while employing more capital, we'd be cautious. This could mean that the business is losing its competitive advantage or market share, because while more money is being put into ventures, it's actually producing a lower return - "less bang for their buck" per se.
On a separate but related note, it's important to know that WashTec has a current liabilities to total assets ratio of 49%, which we'd consider pretty high. This can bring about some risks because the company is basically operating with a rather large reliance on its suppliers or other sorts of short-term creditors. Ideally we'd like to see this reduce as that would mean fewer obligations bearing risks.
The Bottom Line
From the above analysis, we find it rather worrisome that returns on capital and sales for WashTec have fallen, meanwhile the business is employing more capital than it was five years ago. However the stock has delivered a 74% return to shareholders over the last five years, so investors might be expecting the trends to turn around. In any case, the current underlying trends don't bode well for long term performance so unless they reverse, we'd start looking elsewhere.
WashTec does have some risks though, and we've spotted 1 warning sign for WashTec that you might be interested in.
If you'd like to see other companies earning high returns, check out our free list of companies earning high returns with solid balance sheets here.
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