AO World's (LON:AO.) Returns On Capital Are Heading Higher

What trends should we look for it we want to identify stocks that can multiply in value over the long term? 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. So when we looked at AO World (LON:AO.) and its trend of ROCE, we really liked what we saw.

What is 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. Analysts use this formula to calculate it for AO World:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.17 = UK£32m ÷ (UK£616m - UK£433m) (Based on the trailing twelve months to March 2021).

Therefore, AO World has an ROCE of 17%. By itself that's a normal return on capital and it's in line with the industry's average returns of 17%.

View our latest analysis for AO World

Above you can see how the current ROCE for AO World 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 AO World here for free.

So How Is AO World's ROCE Trending?

The fact that AO World is now generating some pre-tax profits from its prior investments is very encouraging. The company was generating losses five years ago, but now it's earning 17% which is a sight for sore eyes. Not only that, but the company is utilizing 222% more capital than before, but that's to be expected from a company trying to break into profitability. We like this trend, because it tells us the company has profitable reinvestment opportunities available to it, and if it continues going forward that can lead to a multi-bagger performance.

On a separate but related note, it's important to know that AO World has a current liabilities to total assets ratio of 70%, 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. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.

What We Can Learn From AO World's ROCE

To the delight of most shareholders, AO World has now broken into profitability. Since the stock has only returned 30% to shareholders over the last five years, the promising fundamentals may not be recognized yet by investors. So with that in mind, we think the stock deserves further research.

While AO World looks impressive, no company is worth an infinite price. The intrinsic value infographic in our free research report helps visualize whether AO. is currently trading for a fair price.

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.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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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