What are the early trends we should look for to identify a stock that could multiply in value over the long term? Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base 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. Although, when we looked at Acacia Communications (NASDAQ:ACIA), it didn't seem to tick all of these boxes.
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. The formula for this calculation on Acacia Communications is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.074 = US$51m ÷ (US$831m - US$140m) (Based on the trailing twelve months to September 2020).
Thus, Acacia Communications has an ROCE of 7.4%. On its own, that's a low figure but it's around the 9.2% average generated by the Communications industry.
In the above chart we have measured Acacia Communications' 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.
How Are Returns Trending?
When we looked at the ROCE trend at Acacia Communications, we didn't gain much confidence. To be more specific, ROCE has fallen from 53% over the last five years. 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.On a side note, Acacia Communications has done well to pay down its current liabilities to 17% of total assets. That could partly explain why the ROCE has dropped. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.
Our Take On Acacia Communications' ROCE
In summary, despite lower returns in the short term, we're encouraged to see that Acacia Communications is reinvesting for growth and has higher sales as a result. And the stock has done incredibly well with a 207% return over the last three years, so long term investors are no doubt ecstatic with that result. So should these growth trends continue, we'd be optimistic on the stock going forward.
One more thing: We've identified 3 warning signs with Acacia Communications (at least 1 which can't be ignored) , and understanding these would certainly be useful.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
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