Capital Allocation Trends At IAA (NYSE:IAA) Aren't Ideal

What are the early trends we should look for to identify a stock that could multiply in value over the long term? 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. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. Having said that, from a first glance at IAA (NYSE:IAA) 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)

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Analysts use this formula to calculate it for IAA:

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

0.17 = US$433m ÷ (US$2.8b - US$334m) (Based on the trailing twelve months to September 2021).

So, IAA has an ROCE of 17%. In absolute terms, that's a satisfactory return, but compared to the Commercial Services industry average of 8.8% it's much better.

See our latest analysis for IAA

Above you can see how the current ROCE for IAA compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

What Can We Tell From IAA's ROCE Trend?

When we looked at the ROCE trend at IAA, we didn't gain much confidence. To be more specific, ROCE has fallen from 28% over the last four years. 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. If these investments prove successful, this can bode very well for long term stock performance.

On a related note, IAA has decreased its current liabilities to 12% of total assets. So we could link some of this to the decrease in ROCE. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.

The Key Takeaway

In summary, despite lower returns in the short term, we're encouraged to see that IAA is reinvesting for growth and has higher sales as a result. These growth trends haven't led to growth returns though, since the stock has fallen 22% over the last year. As a result, we'd recommend researching this stock further to uncover what other fundamentals of the business can show us.

Like most companies, IAA does come with some risks, and we've found 1 warning sign that you should be aware of.

While IAA isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

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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.