Capital Allocation Trends At Severn Trent (LON:SVT) Aren't Ideal

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. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. Having said that, from a first glance at Severn Trent (LON:SVT) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.

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 Severn Trent, this is the formula:

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

0.043 = UK£494m ÷ (UK£13b - UK£1.3b) (Based on the trailing twelve months to September 2023).

Therefore, Severn Trent has an ROCE of 4.3%. On its own that's a low return, but compared to the average of 1.6% generated by the Water Utilities industry, it's much better.

See our latest analysis for Severn Trent

Above you can see how the current ROCE for Severn Trent 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 analyst report for Severn Trent .

The Trend Of ROCE

In terms of Severn Trent's historical ROCE movements, the trend isn't fantastic. Around five years ago the returns on capital were 6.1%, but since then they've fallen to 4.3%. 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. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.

Our Take On Severn Trent's ROCE

In summary, despite lower returns in the short term, we're encouraged to see that Severn Trent is reinvesting for growth and has higher sales as a result. Furthermore the stock has climbed 57% over the last five years, it would appear that investors are upbeat about the future. So while investors seem to be recognizing these promising trends, we would look further into this stock to make sure the other metrics justify the positive view.

On a final note, we found 4 warning signs for Severn Trent (2 are potentially serious) you should be aware of.

While Severn Trent 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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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.