Returns On Capital At Severn Trent (LON:SVT) Paint A Concerning Picture

What are the early trends we should look for to identify a stock that could multiply in value over the long term? 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 Severn Trent (LON:SVT) has the makings of a multi-bagger going forward, but let's have a look at why that may be.

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. 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)

0.048 = UK£500m ÷ (UK£12b - UK£1.1b) (Based on the trailing twelve months to March 2022).

So, Severn Trent has an ROCE of 4.8%. In absolute terms, that's a low return, but it's much better than the Water Utilities industry average of 3.9%.

Our analysis indicates that SVT is potentially overvalued!

In the above chart we have measured Severn Trent's prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

What The Trend Of ROCE Can Tell Us

On the surface, the trend of ROCE at Severn Trent doesn't inspire confidence. To be more specific, ROCE has fallen from 6.2% over the last five years. Meanwhile, the business is utilizing more capital but this hasn't moved the needle much in terms of sales in the past 12 months, so this could reflect longer term investments. It may take some time before the company starts to see any change in earnings from these investments.

What We Can Learn From Severn Trent's ROCE

Bringing it all together, while we're somewhat encouraged by Severn Trent's reinvestment in its own business, we're aware that returns are shrinking. Unsurprisingly, the stock has only gained 39% over the last five years, which potentially indicates that investors are accounting for this going forward. Therefore, if you're looking for a multi-bagger, we'd propose looking at other options.

Like most companies, Severn Trent does come with some risks, and we've found 2 warning signs that you should be aware of.

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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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.