Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing 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. Speaking of which, we noticed some great changes in A. O. Smith's (NYSE:AOS) returns on capital, so let's have a look.
Return On Capital Employed (ROCE): What Is It?
If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. To calculate this metric for A. O. Smith, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.27 = US$639m ÷ (US$3.2b - US$901m) (Based on the trailing twelve months to September 2022).
Thus, A. O. Smith has an ROCE of 27%. That's a fantastic return and not only that, it outpaces the average of 14% earned by companies in a similar industry.
Above you can see how the current ROCE for A. O. Smith compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like to see what analysts are forecasting going forward, you should check out our free report for A. O. Smith.
What Does the ROCE Trend For A. O. Smith Tell Us?
A. O. Smith is showing promise given that its ROCE is trending up and to the right. The figures show that over the last five years, ROCE has grown 32% whilst employing roughly the same amount of capital. So our take on this is that the business has increased efficiencies to generate these higher returns, all the while not needing to make any additional investments. It's worth looking deeper into this though because while it's great that the business is more efficient, it might also mean that going forward the areas to invest internally for the organic growth are lacking.
To sum it up, A. O. Smith is collecting higher returns from the same amount of capital, and that's impressive. And given the stock has remained rather flat over the last five years, there might be an opportunity here if other metrics are strong. That being the case, research into the company's current valuation metrics and future prospects seems fitting.
A. O. Smith does have some risks though, and we've spotted 1 warning sign for A. O. Smith that you might be interested in.
If you want to search for more stocks that have been earning high returns, check out this free list of stocks with solid balance sheets that are also earning high returns on equity.
What are the risks and opportunities for A. O. Smith?
Earnings are forecast to grow 13.48% per year
Earnings have grown 8.1% per year over the past 5 years
Significant insider selling over the past 3 months
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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.
A. O. Smith
A. O. Smith Corporation manufactures and markets residential and commercial gas, heat pump and electric water heaters, boilers, tanks, and water treatment products in North America, China, Europe, and India.
Flawless balance sheet established dividend payer.