Severn Trent (LON:SVT) Will Be Hoping To Turn Its Returns On Capital Around

If you're not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out for. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. 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.

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 Severn Trent:

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

0.048 = UK£508m ÷ (UK£12b - UK£1.4b) (Based on the trailing twelve months to September 2022).

Therefore, 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%.

View 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 The Trend Of ROCE Can Tell Us

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 4.8% from 6.2% five years ago. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It may take some time before the company starts to see any change in earnings from these investments.

In Conclusion...

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. Since the stock has gained an impressive 86% over the last five years, investors must think there's better things to come. But if the trajectory of these underlying trends continue, we think the likelihood of it being a multi-bagger from here isn't high.

If you'd like to know more about Severn Trent, we've spotted 3 warning signs, and 2 of them shouldn't be ignored.

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.

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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.