If you're looking for a multi-bagger, there's a few things to keep an eye out for. 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. Having said that, from a first glance at Somany Home Innovation (NSE:SHIL) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.
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 Somany Home Innovation, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.18 = ₹740m ÷ (₹9.4b - ₹5.4b) (Based on the trailing twelve months to December 2020).
Therefore, Somany Home Innovation has an ROCE of 18%. On its own, that's a standard return, however it's much better than the 6.2% generated by the Trade Distributors industry.
Historical performance is a great place to start when researching a stock so above you can see the gauge for Somany Home Innovation's ROCE against it's prior returns. If you want to delve into the historical earnings, revenue and cash flow of Somany Home Innovation, check out these free graphs here.
How Are Returns Trending?
On the surface, the trend of ROCE at Somany Home Innovation doesn't inspire confidence. Over the last two years, returns on capital have decreased to 18% from 50% two years ago. And considering revenue has dropped while employing more capital, we'd be cautious. This could mean that the business is losing its competitive advantage or market share, because while more money is being put into ventures, it's actually producing a lower return - "less bang for their buck" per se.
On a separate but related note, it's important to know that Somany Home Innovation has a current liabilities to total assets ratio of 57%, which we'd consider pretty high. This can bring about some risks because the company is basically operating with a rather large reliance on its suppliers or other sorts of short-term creditors. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.
The Key Takeaway
We're a bit apprehensive about Somany Home Innovation because despite more capital being deployed in the business, returns on that capital and sales have both fallen. Yet despite these poor fundamentals, the stock has gained a huge 142% over the last year, so investors appear very optimistic. In any case, the current underlying trends don't bode well for long term performance so unless they reverse, we'd start looking elsewhere.
If you want to know some of the risks facing Somany Home Innovation we've found 3 warning signs (2 don't sit too well with us!) that you should be aware of before investing here.
While Somany Home Innovation isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.
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