Returns On Capital At Xylem (NYSE:XYL) Have Hit The Brakes

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. In a perfect world, we'd like to see a company investing more capital into its business and ideally the returns earned from that capital are also increasing. 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 Xylem (NYSE:XYL) 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)

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. Analysts use this formula to calculate it for Xylem:

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

0.088 = US$546m ÷ (US$8.2b - US$2.0b) (Based on the trailing twelve months to June 2022).

So, Xylem has an ROCE of 8.8%. In absolute terms, that's a low return but it's around the Machinery industry average of 10%.

Check out the opportunities and risks within the US Machinery industry.

In the above chart we have measured Xylem'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 Xylem here for free.

What Does the ROCE Trend For Xylem Tell Us?

There hasn't been much to report for Xylem's returns and its level of capital employed because both metrics have been steady for the past five years. This tells us the company isn't reinvesting in itself, so it's plausible that it's past the growth phase. So don't be surprised if Xylem doesn't end up being a multi-bagger in a few years time. This probably explains why Xylem is paying out 35% 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.

In Conclusion...

In summary, Xylem isn't compounding its earnings but is generating stable returns on the same amount of capital employed. Although the market must be expecting these trends to improve because the stock has gained 45% over the last five years. 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 want to know some of the risks facing Xylem we've found 2 warning signs (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

While Xylem may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.

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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.