There are a few key trends to look for if we want to identify the next multi-bagger. 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. So when we looked at Italtile (JSE:ITE), they do have a high ROCE, but we weren't exactly elated from how returns are trending.
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. To calculate this metric for Italtile, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.23 = R1.5b ÷ (R7.4b - R779m) (Based on the trailing twelve months to June 2020).
So, Italtile has an ROCE of 23%. That's a fantastic return and not only that, it outpaces the average of 14% earned by companies in a similar industry.
While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you'd like to look at how Italtile has performed in the past in other metrics, you can view this free graph of past earnings, revenue and cash flow.
So How Is Italtile's ROCE Trending?
When we looked at the ROCE trend at Italtile, we didn't gain much confidence. Historically returns on capital were even higher at 32%, but they have dropped over the last five years. Meanwhile, the business is utilizing more capital but this hasn't moved the needle much in terms of sales in the past 12 months, so this could reflect longer term investments. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.
Bringing it all together, while we're somewhat encouraged by Italtile'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 50% 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.
Italtile does have some risks though, and we've spotted 1 warning sign for Italtile that you might be interested in.
High returns are a key ingredient to strong performance, so check out our free list ofstocks earning high returns on equity with solid balance sheets.
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