If you're not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out for. One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing 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. However, after investigating Contact Energy (NZSE:CEN), we don't think it's current trends fit the mold of a multi-bagger.
Understanding Return On Capital Employed (ROCE)
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. The formula for this calculation on Contact Energy is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.069 = NZ$304m ÷ (NZ$5.0b - NZ$622m) (Based on the trailing twelve months to June 2021).
So, Contact Energy has an ROCE of 6.9%. On its own, that's a low figure but it's around the 6.1% average generated by the Electric Utilities industry.
In the above chart we have measured Contact Energy's prior ROCE against its prior performance, but the future is arguably more important. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Contact Energy.
What Can We Tell From Contact Energy's ROCE Trend?
Over the past five years, Contact Energy's ROCE and capital employed have both remained mostly flat. It's not uncommon to see this when looking at a mature and stable business that isn't re-investing its earnings because it has likely passed that phase of the business cycle. So don't be surprised if Contact Energy doesn't end up being a multi-bagger in a few years time. On top of that you'll notice that Contact Energy has been paying out a large portion (149%) of earnings in the form of dividends to shareholders. These mature businesses typically have reliable earnings and not many places to reinvest them, so the next best option is to put the earnings into shareholders pockets.
In summary, Contact Energy isn't compounding its earnings but is generating stable returns on the same amount of capital employed. Yet to long term shareholders the stock has gifted them an incredible 131% return in the last five years, so the market appears to be rosy about its future. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.
Contact Energy does have some risks, we noticed 3 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.
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.
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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