If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. 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. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. Speaking of which, we noticed some great changes in Arjo's (STO:ARJO B) returns on capital, so let's have a look.
Understanding Return On Capital Employed (ROCE)
For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. To calculate this metric for Arjo, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.11 = kr1.0b ÷ (kr14b - kr4.8b) (Based on the trailing twelve months to June 2021).
Therefore, Arjo has an ROCE of 11%. That's a pretty standard return and it's in line with the industry average of 11%.
In the above chart we have measured Arjo's prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.
What Can We Tell From Arjo's ROCE Trend?
We're pretty happy with how the ROCE has been trending at Arjo. We found that the returns on capital employed over the last five years have risen by 60%. That's a very favorable trend because this means that the company is earning more per dollar of capital that's being employed. Speaking of capital employed, the company is actually utilizing 21% less than it was five years ago, which can be indicative of a business that's improving its efficiency. A business that's shrinking its asset base like this isn't usually typical of a soon to be multi-bagger company.
For the record though, there was a noticeable increase in the company's current liabilities over the period, so we would attribute some of the ROCE growth to that. The current liabilities has increased to 35% of total assets, so the business is now more funded by the likes of its suppliers or short-term creditors. Keep an eye out for future increases because when the ratio of current liabilities to total assets gets particularly high, this can introduce some new risks for the business.
The Key Takeaway
From what we've seen above, Arjo has managed to increase it's returns on capital all the while reducing it's capital base. Since the stock has returned a staggering 282% to shareholders over the last three years, it looks like investors are recognizing these changes. So given the stock has proven it has promising trends, it's worth researching the company further to see if these trends are likely to persist.
Like most companies, Arjo does come with some risks, and we've found 1 warning sign 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.
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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