If we want to find a stock that could multiply over the long term, what are the underlying trends we should look 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. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. Speaking of which, we noticed some great changes in Franklin Electric's (NASDAQ:FELE) returns on capital, so let's have a look.
What is 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. To calculate this metric for Franklin Electric, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.15 = US$175m ÷ (US$1.5b - US$401m) (Based on the trailing twelve months to September 2021).
Thus, Franklin Electric has an ROCE of 15%. In absolute terms, that's a satisfactory return, but compared to the Machinery industry average of 10% it's much better.
In the above chart we have measured Franklin Electric'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 Does the ROCE Trend For Franklin Electric Tell Us?
We like the trends that we're seeing from Franklin Electric. The data shows that returns on capital have increased substantially over the last five years to 15%. The company is effectively making more money per dollar of capital used, and it's worth noting that the amount of capital has increased too, by 29%. The increasing returns on a growing amount of capital is common amongst multi-baggers and that's why we're impressed.
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 26% 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.
What We Can Learn From Franklin Electric's ROCE
A company that is growing its returns on capital and can consistently reinvest in itself is a highly sought after trait, and that's what Franklin Electric has. And with the stock having performed exceptionally well over the last five years, these patterns are being accounted for by investors. With that being said, we still think the promising fundamentals mean the company deserves some further due diligence.
One more thing to note, we've identified 1 warning sign with Franklin Electric and understanding this should be part of your investment process.
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.
Valuation is complex, but we're helping make it simple.
Find out whether Franklin Electric is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.View the Free Analysis
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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.