There Are Reasons To Feel Uneasy About Severn Trent's (LON:SVT) Returns On Capital

What are the early trends we should look for to identify a stock that could 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. However, after investigating Severn Trent (LON:SVT), we don't think it's current trends fit the mold of a multi-bagger.

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. The formula for this calculation on Severn Trent is:

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

0.046 = UK£509m ÷ (UK£12b - UK£1.1b) (Based on the trailing twelve months to March 2023).

Therefore, Severn Trent has an ROCE of 4.6%. In absolute terms, that's a low return but it's around the Water Utilities industry average of 3.9%.

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 to see what analysts are forecasting going forward, you should check out our free report for Severn Trent.

What Does the ROCE Trend For Severn Trent 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 4.6% from 6.1% five years ago. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. If these investments prove successful, this can bode very well for long term stock performance.

Our Take On Severn Trent's ROCE

Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Severn Trent. And the stock has followed suit returning a meaningful 69% to shareholders over the last five years. So while the underlying trends could already be accounted for by investors, we still think this stock is worth looking into further.

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

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.