If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Amongst other things, we'll want to see two things; firstly, a growing return on capital employed (ROCE) and secondly, an expansion in the company's 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. Although, when we looked at Colonial Motor (NZSE:CMO), it didn't seem to tick all of these boxes.
What is 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. Analysts use this formula to calculate it for Colonial Motor:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.15 = NZ$36m ÷ (NZ$381m - NZ$133m) (Based on the trailing twelve months to December 2020).
Therefore, Colonial Motor has an ROCE of 15%. That's a pretty standard return and it's in line with the industry average of 15%.
Historical performance is a great place to start when researching a stock so above you can see the gauge for Colonial Motor's ROCE against it's prior returns. If you'd like to look at how Colonial Motor has performed in the past in other metrics, you can view this free graph of past earnings, revenue and cash flow.
The Trend Of ROCE
On the surface, the trend of ROCE at Colonial Motor doesn't inspire confidence. Over the last five years, returns on capital have decreased to 15% from 19% five years ago. However it looks like Colonial Motor might be reinvesting for long term growth because while capital employed has increased, the company's sales haven't changed much in the last 12 months. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.
In summary, Colonial Motor is reinvesting funds back into the business for growth but unfortunately it looks like sales haven't increased much just yet. Investors must think there's better things to come because the stock has knocked it out of the park, delivering a 104% gain to shareholders who have held over the last five years. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.
Colonial Motor does have some risks though, and we've spotted 1 warning sign for Colonial Motor that you might be interested in.
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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