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. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, 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 GYG (LON:GYG), we don't think it's current trends fit the mold of a multi-bagger.
Return On Capital Employed (ROCE): What is it?
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 GYG, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.095 = €1.7m ÷ (€48m - €30m) (Based on the trailing twelve months to June 2020).
Thus, GYG has an ROCE of 9.5%. On its own, that's a low figure but it's around the 11% average generated by the Commercial Services industry.
In the above chart we have measured GYG's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering GYG here for free.
The Trend Of ROCE
On the surface, the trend of ROCE at GYG doesn't inspire confidence. Over the last five years, returns on capital have decreased to 9.5% from 47% five years ago. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. If these investments prove successful, this can bode very well for long term stock performance.On a separate but related note, it's important to know that GYG has a current liabilities to total assets ratio of 62%, which we'd consider pretty high. This effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. Ideally we'd like to see this reduce as that would mean fewer obligations bearing risks.
What We Can Learn From GYG's ROCE
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for GYG. These growth trends haven't led to growth returns though, since the stock has fallen 51% over the last three years. As a result, we'd recommend researching this stock further to uncover what other fundamentals of the business can show us.
If you want to know some of the risks facing GYG we've found 3 warning signs (1 is a bit concerning!) that you should be aware of before investing here.
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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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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