If you're not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out for. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding 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. Having said that, while the ROCE is currently high for frontdoor (NASDAQ:FTDR), we aren't jumping out of our chairs because returns are decreasing.
Understanding Return On Capital Employed (ROCE)
For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. Analysts use this formula to calculate it for frontdoor:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.22 = US$202m ÷ (US$1.4b - US$439m) (Based on the trailing twelve months to March 2021).
So, frontdoor has an ROCE of 22%. That's a fantastic return and not only that, it outpaces the average of 8.1% earned by companies in a similar industry.
Above you can see how the current ROCE for frontdoor 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 frontdoor here for free.
So How Is frontdoor's ROCE Trending?
When we looked at the ROCE trend at frontdoor, we didn't gain much confidence. While it's comforting that the ROCE is high, four years ago it was 31%. However it looks like frontdoor might be reinvesting for long term growth because while capital employed has increased, the company's sales haven't changed much in the last 12 months. It may take some time before the company starts to see any change in earnings from these investments.
On a related note, frontdoor has decreased its current liabilities to 32% 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, frontdoor is reinvesting funds back into the business for growth but unfortunately it looks like sales haven't increased much just yet. Since the stock has gained an impressive 15% over the last year, investors must think there's better things to come. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.
frontdoor does come with some risks though, we found 3 warning signs in our investment analysis, and 1 of those is a bit concerning...
If you'd like to see other companies earning high returns, check out our free list of companies earning high returns with solid balance sheets here.
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