What are the early trends we should look for to identify a stock that could multiply in value over the long term? Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base 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. Although, when we looked at Sally Beauty Holdings (NYSE:SBH), it didn't seem to tick all of these boxes.
Return On Capital Employed (ROCE): What is it?
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. The formula for this calculation on Sally Beauty Holdings is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.12 = US$282m ÷ (US$3.0b - US$590m) (Based on the trailing twelve months to December 2020).
Therefore, Sally Beauty Holdings has an ROCE of 12%. In absolute terms, that's a pretty normal return, and it's somewhat close to the Specialty Retail industry average of 13%.
In the above chart we have measured Sally Beauty Holdings' prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.
The Trend Of ROCE
When we looked at the ROCE trend at Sally Beauty Holdings, we didn't gain much confidence. Around five years ago the returns on capital were 33%, but since then they've fallen to 12%. Given the business is employing more capital while revenue has slipped, this is a bit concerning. This could mean that the business is losing its competitive advantage or market share, because while more money is being put into ventures, it's actually producing a lower return - "less bang for their buck" per se.
What We Can Learn From Sally Beauty Holdings' ROCE
In summary, we're somewhat concerned by Sally Beauty Holdings' diminishing returns on increasing amounts of capital. Long term shareholders who've owned the stock over the last five years have experienced a 35% depreciation in their investment, so it appears the market might not like these trends either. With underlying trends that aren't great in these areas, we'd consider looking elsewhere.
Since virtually every company faces some risks, it's worth knowing what they are, and we've spotted 3 warning signs for Sally Beauty Holdings (of which 1 shouldn't be ignored!) that you should know about.
While Sally Beauty Holdings 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. 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.
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