To find a multi-bagger stock, what are the underlying trends we should look for in a business? 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. Having said that, while the ROCE is currently high for Perennial Energy Holdings (HKG:2798), we aren't jumping out of our chairs because returns are decreasing.
Understanding Return On Capital Employed (ROCE)
If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. To calculate this metric for Perennial Energy Holdings, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.26 = CN¥575m ÷ (CN¥2.7b - CN¥435m) (Based on the trailing twelve months to June 2021).
Thus, Perennial Energy Holdings has an ROCE of 26%. In absolute terms that's a great return and it's even better than the Metals and Mining industry average of 12%.
While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you're interested in investigating Perennial Energy Holdings' past further, check out this free graph of past earnings, revenue and cash flow.
The Trend Of ROCE
When we looked at the ROCE trend at Perennial Energy Holdings, we didn't gain much confidence. While it's comforting that the ROCE is high, five years ago it was 41%. 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. If these investments prove successful, this can bode very well for long term stock performance.
On a side note, Perennial Energy Holdings has done well to pay down its current liabilities to 16% of total assets. Considering it used to be 70%, that's a huge drop in that ratio and it would explain the decline in ROCE. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.
The Key Takeaway
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Perennial Energy Holdings. And there could be an opportunity here if other metrics look good too, because the stock has declined 60% in the last year. As a result, we'd recommend researching this stock further to uncover what other fundamentals of the business can show us.
If you'd like to know more about Perennial Energy Holdings, we've spotted 2 warning signs, and 1 of them is concerning.
If you want to search for more stocks that have been earning high returns, check out this free list of stocks with solid balance sheets that are also earning high 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.
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