If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. Having said that, from a first glance at Argan (NYSE:AGX) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.
Understanding Return On Capital Employed (ROCE)
Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. To calculate this metric for Argan, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.071 = US$23m ÷ (US$603m - US$276m) (Based on the trailing twelve months to January 2021).
Therefore, Argan has an ROCE of 7.1%. Ultimately, that's a low return and it under-performs the Construction industry average of 9.5%.
In the above chart we have measured Argan'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 Argan.
What Does the ROCE Trend For Argan Tell Us?
When we looked at the ROCE trend at Argan, we didn't gain much confidence. Around five years ago the returns on capital were 33%, but since then they've fallen to 7.1%. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.
On a side note, Argan's current liabilities are still rather high at 46% of total assets. This effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. Ideally we'd like to see this reduce as that would mean fewer obligations bearing risks.
The Bottom Line On Argan's ROCE
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Argan. These trends are starting to be recognized by investors since the stock has delivered a 31% gain to shareholders who've held over the last five years. So this stock may still be an appealing investment opportunity, if other fundamentals prove to be sound.
On a final note, we've found 2 warning signs for Argan that we think 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.
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