Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. 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. However, after investigating Ponsse Oyj (HEL:PON1V), we don't think it's current trends fit the mold of a multi-bagger.
What is Return On Capital Employed (ROCE)?
Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. To calculate this metric for Ponsse Oyj, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.19 = €59m ÷ (€451m - €134m) (Based on the trailing twelve months to March 2021).
Therefore, Ponsse Oyj has an ROCE of 19%. In absolute terms, that's a satisfactory return, but compared to the Machinery industry average of 9.6% it's much better.
Above you can see how the current ROCE for Ponsse Oyj 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.
How Are Returns Trending?
On the surface, the trend of ROCE at Ponsse Oyj doesn't inspire confidence. Around five years ago the returns on capital were 36%, but since then they've fallen to 19%. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It may take some time before the company starts to see any change in earnings from these investments.
Our Take On Ponsse Oyj's ROCE
Bringing it all together, while we're somewhat encouraged by Ponsse Oyj's reinvestment in its own business, we're aware that returns are shrinking. Investors must think there's better things to come because the stock has knocked it out of the park, delivering a 130% gain to shareholders who have held 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 Ponsse Oyj and understanding this should be part of your investment process.
While Ponsse Oyj isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.
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