Capital Allocation Trends At MGE Energy (NASDAQ:MGEE) Aren't Ideal

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look 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. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. In light of that, when we looked at MGE Energy (NASDAQ:MGEE) and its ROCE trend, we weren't exactly thrilled.

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. The formula for this calculation on MGE Energy is:

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

0.06 = US$123m ÷ (US$2.3b - US$191m) (Based on the trailing twelve months to December 2020).

Therefore, MGE Energy has an ROCE of 6.0%. On its own that's a low return, but compared to the average of 4.4% generated by the Electric Utilities industry, it's much better.

View our latest analysis for MGE Energy

Above you can see how the current ROCE for MGE Energy 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 MGE Energy here for free.

So How Is MGE Energy's ROCE Trending?

Unfortunately, the trend isn't great with ROCE falling from 7.6% five years ago, while capital employed has grown 26%. However, some of the increase in capital employed could be attributed to the recent capital raising that's been completed prior to their latest reporting period, so keep that in mind when looking at the ROCE decrease. It's unlikely that all of the funds raised have been put to work yet, so as a consequence MGE Energy might not have received a full period of earnings contribution from it. Additionally, we found that MGE Energy's most recent EBIT figure is around the same as the prior year, so we'd attribute the drop in ROCE mostly to the capital raise.

The Bottom Line On MGE Energy's ROCE

Bringing it all together, while we're somewhat encouraged by MGE Energy's reinvestment in its own business, we're aware that returns are shrinking. Although the market must be expecting these trends to improve because the stock has gained 61% over the last five years. But if the trajectory of these underlying trends continue, we think the likelihood of it being a multi-bagger from here isn't high.

Like most companies, MGE Energy does come with some risks, and we've found 2 warning signs that you should be aware of.

If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive returns on equity.

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