Some Investors May Be Worried About Energy Recovery's (NASDAQ:ERII) Returns On Capital

What trends should we look for it we want to identify stocks that can multiply in value over the long term? 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 briefly looking over the numbers, we don't think Energy Recovery (NASDAQ:ERII) has the makings of a multi-bagger going forward, but let's have a look at why that may be.

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 Energy Recovery:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.063 = US$13m ÷ (US$223m - US$16m) (Based on the trailing twelve months to September 2023).

Therefore, Energy Recovery has an ROCE of 6.3%. Ultimately, that's a low return and it under-performs the Machinery industry average of 12%.

Check out our latest analysis for Energy Recovery

In the above chart we have measured Energy Recovery's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Energy Recovery here for free.

How Are Returns Trending?

On the surface, the trend of ROCE at Energy Recovery doesn't inspire confidence. Over the last five years, returns on capital have decreased to 6.3% from 9.0% five years ago. However it looks like Energy Recovery 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 may take some time before the company starts to see any change in earnings from these investments.

The Bottom Line On Energy Recovery's ROCE

Bringing it all together, while we're somewhat encouraged by Energy Recovery's reinvestment in its own business, we're aware that returns are shrinking. Yet to long term shareholders the stock has gifted them an incredible 137% return in the last five years, so the market appears to be rosy about its future. But if the trajectory of these underlying trends continue, we think the likelihood of it being a multi-bagger from here isn't high.

If you'd like to know about the risks facing Energy Recovery, we've discovered 1 warning sign that you should be aware of.

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.