Severn Trent (LON:SVT) Is Reinvesting At Lower Rates Of Return

What are the early trends we should look for to identify a stock that could multiply in value over the long term? Amongst other things, we'll want to see two things; firstly, a growing return on capital employed (ROCE) and secondly, an expansion in the company's 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. 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.

Understanding 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. 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)

0.047 = UK£465m ÷ (UK£11b - UK£1.1b) (Based on the trailing twelve months to March 2021).

So, Severn Trent has an ROCE of 4.7%. On its own that's a low return on capital but it's in line with the industry's average returns of 4.7%.

See our latest analysis for Severn Trent

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'd like, you can check out the forecasts from the analysts covering Severn Trent here for free.

What Can We Tell From Severn Trent's ROCE Trend?

When we looked at the ROCE trend at Severn Trent, we didn't gain much confidence. Over the last five years, returns on capital have decreased to 4.7% from 6.3% five years ago. However it looks like Severn Trent might be reinvesting for long term growth because while capital employed has increased, the company's sales haven't changed much in the last 12 months. It may take some time before the company starts to see any change in earnings from these investments.

The Bottom Line On Severn Trent's ROCE

To conclude, we've found that Severn Trent is reinvesting in the business, but returns have been falling. Although the market must be expecting these trends to improve because the stock has gained 41% over the last five years. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.

Severn Trent does have some risks, we noticed 3 warning signs (and 1 which doesn't sit too well with us) we think you should know about.

While Severn Trent may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.

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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