What are the early trends we should look for to identify a stock that could multiply in value over the long term? 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. With that in mind, we've noticed some promising trends at Nippo (TYO:9913) so let's look a bit deeper.
Return On Capital Employed (ROCE): What is it?
If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. The formula for this calculation on Nippo is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.044 = JP¥590m ÷ (JP¥25b - JP¥12b) (Based on the trailing twelve months to December 2020).
Thus, Nippo has an ROCE of 4.4%. In absolute terms, that's a low return and it also under-performs the Electronic industry average of 7.2%.
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 want to delve into the historical earnings, revenue and cash flow of Nippo, check out these free graphs here.
The Trend Of ROCE
We're delighted to see that Nippo is reaping rewards from its investments and has now broken into profitability. The company now earns 4.4% on its capital, because five years ago it was incurring losses. On top of that, what's interesting is that the amount of capital being employed has remained steady, so the business hasn't needed to put any additional money to work to generate these higher returns. So while we're happy that the business is more efficient, just keep in mind that could mean that going forward the business is lacking areas to invest internally for growth. After all, a company can only become a long term multi-bagger if it continually reinvests in itself at high rates of return.
Another thing to note, Nippo has a high ratio of current liabilities to total assets of 47%. This effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.
The Bottom Line
As discussed above, Nippo appears to be getting more proficient at generating returns since capital employed has remained flat but earnings (before interest and tax) are up. And with the stock having performed exceptionally well over the last five years, these patterns are being accounted for by investors. Therefore, we think it would be worth your time to check if these trends are going to continue.
If you'd like to know about the risks facing Nippo, we've discovered 2 warning signs that you should be aware of.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
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