What are the early trends we should look for to identify a stock that could multiply in value over the long term? Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. However, after briefly looking over the numbers, we don't think Eaton (NYSE:ETN) has the makings of a multi-bagger going forward, but let's have a look at why that may be.
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. Analysts use this formula to calculate it for Eaton:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.10 = US$2.6b ÷ (US$35b - US$9.0b) (Based on the trailing twelve months to June 2022).
So, Eaton has an ROCE of 10%. In absolute terms, that's a satisfactory return, but compared to the Electrical industry average of 8.0% it's much better.
Above you can see how the current ROCE for Eaton compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Eaton here for free.
What Does the ROCE Trend For Eaton Tell Us?
Things have been pretty stable at Eaton, with its capital employed and returns on that capital staying somewhat the same for the last five years. It's not uncommon to see this when looking at a mature and stable business that isn't re-investing its earnings because it has likely passed that phase of the business cycle. With that in mind, unless investment picks up again in the future, we wouldn't expect Eaton to be a multi-bagger going forward. This probably explains why Eaton is paying out 41% of its income to shareholders in the form of dividends. Unless businesses have highly compelling growth opportunities, they'll typically return some money to shareholders.
The Key Takeaway
In summary, Eaton isn't compounding its earnings but is generating stable returns on the same amount of capital employed. Yet to long term shareholders the stock has gifted them an incredible 121% return in the last five years, so the market appears to be rosy about its future. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.
Since virtually every company faces some risks, it's worth knowing what they are, and we've spotted 4 warning signs for Eaton (of which 1 doesn't sit too well with us!) that you should know about.
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.