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. 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, from a first glance at American States Water (NYSE:AWR) 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)
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 American States Water is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.08 = US$134m ÷ (US$1.8b - US$119m) (Based on the trailing twelve months to December 2020).
Thus, American States Water has an ROCE of 8.0%. On its own that's a low return, but compared to the average of 4.8% generated by the Water Utilities industry, it's much better.
In the above chart we have measured American States Water's prior ROCE against its prior performance, but the future is arguably more important. If you'd like to see what analysts are forecasting going forward, you should check out our free report for American States Water.
What The Trend Of ROCE Can Tell Us
The returns on capital haven't changed much for American States Water in recent years. Over the past five years, ROCE has remained relatively flat at around 8.0% and the business has deployed 37% more capital into its operations. Given the company has increased the amount of capital employed, it appears the investments that have been made simply don't provide a high return on capital.
What We Can Learn From American States Water's ROCE
As we've seen above, American States Water's returns on capital haven't increased but it is reinvesting in the business. Yet to long term shareholders the stock has gifted them an incredible 118% return in the last five years, so the market appears to be rosy about its future. But if the trajectory of these underlying trends continue, we think the likelihood of it being a multi-bagger from here isn't high.
On a final note, we've found 1 warning sign for American States Water that we think you should be aware of.
While American States Water isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.
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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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