What trends should we look for it we want to identify stocks that can multiply in value over the long term? Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, 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. So, when we ran our eye over Johnson Matthey's (LON:JMAT) trend of ROCE, we liked what we saw.
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. The formula for this calculation on Johnson Matthey is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.12 = UK£510m ÷ (UK£7.7b - UK£3.6b) (Based on the trailing twelve months to March 2021).
Therefore, Johnson Matthey has an ROCE of 12%. That's a relatively normal return on capital, and it's around the 11% generated by the Chemicals industry.
Above you can see how the current ROCE for Johnson Matthey 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 Johnson Matthey here for free.
The Trend Of ROCE
While the current returns on capital are decent, they haven't changed much. The company has consistently earned 12% for the last five years, and the capital employed within the business has risen 42% in that time. Since 12% is a moderate ROCE though, it's good to see a business can continue to reinvest at these decent rates of return. Stable returns in this ballpark can be unexciting, but if they can be maintained over the long run, they often provide nice rewards to shareholders.
On another note, while the change in ROCE trend might not scream for attention, it's interesting that the current liabilities have actually gone up over the last five years. This is intriguing because if current liabilities hadn't increased to 46% of total assets, this reported ROCE would probably be less than12% because total capital employed would be higher.The 12% ROCE could be even lower if current liabilities weren't 46% of total assets, because the the formula would show a larger base of total capital employed. So with current liabilities at such high levels, this effectively means the likes of suppliers or short-term creditors are funding a meaningful part of the business, which in some instances can bring some risks.
The Bottom Line
To sum it up, Johnson Matthey has simply been reinvesting capital steadily, at those decent rates of return. And given the stock has only risen 17% over the last five years, we'd suspect the market is beginning to recognize these trends. That's why it could be worth your time looking into this stock further to discover if it has more traits of a multi-bagger.
If you want to continue researching Johnson Matthey, you might be interested to know about the 3 warning signs that our analysis has discovered.
If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive returns on equity.
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