If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? In a perfect world, we'd like to see a company investing more capital into its business and ideally the returns earned from that capital are also increasing. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. In light of that, when we looked at adidas (ETR:ADS) and its ROCE trend, we weren't exactly thrilled.
Return On Capital Employed (ROCE): What is it?
If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. The formula for this calculation on adidas is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.066 = €804m ÷ (€21b - €8.8b) (Based on the trailing twelve months to December 2020).
Thus, adidas has an ROCE of 6.6%. In absolute terms, that's a low return but it's around the Luxury industry average of 5.5%.
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'd like to see what analysts are forecasting going forward, you should check out our free report for adidas.
The Trend Of ROCE
When we looked at the ROCE trend at adidas, we didn't gain much confidence. Over the last five years, returns on capital have decreased to 6.6% from 14% 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 side note, adidas' current liabilities are still rather high at 42% of total assets. 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.
The Bottom Line
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. The market must be rosy on the stock's future because even though the underlying trends aren't too encouraging, the stock has soared 199%. In any case, the current underlying trends don't bode well for long term performance so unless they reverse, we'd start looking elsewhere.
On a final note, we've found 3 warning signs for adidas that we think you should be aware of.
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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