What trends should we look for it we want to identify stocks that can multiply in value over the long term? Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base of capital employed. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. Although, when we looked at adidas (ETR:ADS), it didn't seem to tick all of these boxes.
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. To calculate this metric for adidas, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.063 = €790m ÷ (€21b - €8.9b) (Based on the trailing twelve months to September 2020).
Thus, adidas has an ROCE of 6.3%. On its own, that's a low figure but it's around the 5.5% average generated by the Luxury industry.
Above you can see how the current ROCE for adidas compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.
What Can We Tell From adidas' ROCE Trend?
When we looked at the ROCE trend at adidas, we didn't gain much confidence. To be more specific, ROCE has fallen from 14% over the last five years. Given the business is employing more capital while revenue has slipped, this is a bit concerning. 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 adidas has a current liabilities to total assets ratio of 42%, 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. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.
Our Take On adidas' ROCE
From the above analysis, we find it rather worrisome that returns on capital and sales for adidas have fallen, meanwhile the business is employing more capital than it was five years ago. Yet despite these poor fundamentals, the stock has gained a huge 233% over the last five years, so investors appear very optimistic. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.
adidas does have some risks, we noticed 2 warning signs (and 1 which shouldn't be ignored) we think you should know about.
While adidas 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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