What are the early trends we should look for to identify a stock that could multiply in value over the long term? Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base of capital employed. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. Although, when we looked at Sheela Foam (NSE:SFL), it didn't seem to tick all of these boxes.
Return On Capital Employed (ROCE): What is it?
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 Sheela Foam:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.13 = ₹2.3b ÷ (₹24b - ₹5.6b) (Based on the trailing twelve months to March 2022).
Thus, Sheela Foam has an ROCE of 13%. That's a pretty standard return and it's in line with the industry average of 13%.
Above you can see how the current ROCE for Sheela Foam compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Sheela Foam here for free.
What Does the ROCE Trend For Sheela Foam Tell Us?
When we looked at the ROCE trend at Sheela Foam, we didn't gain much confidence. Over the last five years, returns on capital have decreased to 13% from 32% five years ago. 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. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.
On a side note, Sheela Foam has done well to pay down its current liabilities to 24% of total assets. So we could link some of this to the decrease 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.
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Sheela Foam. And the stock has done incredibly well with a 138% return over the last five years, so long term investors are no doubt ecstatic with that result. So while the underlying trends could already be accounted for by investors, we still think this stock is worth looking into further.
One more thing to note, we've identified 1 warning sign with Sheela Foam and understanding this should be part of your investment process.
If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive 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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