If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base 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 briefly looking over the numbers, we don't think Rentokil Initial (LON:RTO) has the makings of a multi-bagger going forward, but let's have a look at why that may be.
Understanding Return On Capital Employed (ROCE)
For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. To calculate this metric for Rentokil Initial, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.11 = UK£329m ÷ (UK£5.8b - UK£3.0b) (Based on the trailing twelve months to December 2020).
So, Rentokil Initial has an ROCE of 11%. By itself that's a normal return on capital and it's in line with the industry's average returns of 11%.
Above you can see how the current ROCE for Rentokil Initial compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Rentokil Initial here for free.
So How Is Rentokil Initial's ROCE Trending?
On the surface, the trend of ROCE at Rentokil Initial doesn't inspire confidence. Over the last five years, returns on capital have decreased to 11% from 16% five years ago. 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's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.
While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 51%, which has impacted the ROCE. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. And with current liabilities at these levels, suppliers or short-term creditors are effectively funding a large part of the business, which can introduce some risks.
The Bottom Line On Rentokil Initial's ROCE
Bringing it all together, while we're somewhat encouraged by Rentokil Initial's reinvestment in its own business, we're aware that returns are shrinking. Yet to long term shareholders the stock has gifted them an incredible 161% return in the last five years, so the market appears to be rosy about its future. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.
One more thing: We've identified 2 warning signs with Rentokil Initial (at least 1 which shouldn't be ignored) , and understanding them would certainly be useful.
While Rentokil Initial 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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