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. 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. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. Having said that, from a first glance at MercadoLibre (NASDAQ:MELI) 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)
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. To calculate this metric for MercadoLibre, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.031 = US$84m ÷ (US$5.7b - US$3.0b) (Based on the trailing twelve months to September 2020).
So, MercadoLibre has an ROCE of 3.1%. In absolute terms, that's a low return and it also under-performs the Online Retail industry average of 11%.
Above you can see how the current ROCE for MercadoLibre 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 MercadoLibre.
So How Is MercadoLibre's ROCE Trending?
When we looked at the ROCE trend at MercadoLibre, we didn't gain much confidence. Around five years ago the returns on capital were 24%, but since then they've fallen to 3.1%. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. If these investments prove successful, this can bode very well for long term stock performance.
While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 52%, which has impacted the ROCE. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. What this means is that in reality, a rather large portion of the business is being funded by the likes of the company's suppliers or short-term creditors, which can bring some risks of its own.
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for MercadoLibre. And long term investors must be optimistic going forward because the stock has returned a huge 1,885% to shareholders in the last five years. So should these growth trends continue, we'd be optimistic on the stock going forward.
On a final note, we found 2 warning signs for MercadoLibre (1 shouldn't be ignored) you should be aware of.
While MercadoLibre 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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