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If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. 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. Speaking of which, we noticed some great changes in AO World's (LON:AO.) returns on capital, so let's have a look.
What Is Return On Capital Employed (ROCE)?
Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Analysts use this formula to calculate it for AO World:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.18 = UK£36m ÷ (UK£442m - UK£244m) (Based on the trailing twelve months to March 2024).
Thus, AO World has an ROCE of 18%. In absolute terms, that's a satisfactory return, but compared to the Specialty Retail industry average of 9.8% it's much better.
Check out our latest analysis for AO World
Above you can see how the current ROCE for AO World compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like to see what analysts are forecasting going forward, you should check out our free analyst report for AO World .
How Are Returns Trending?
Shareholders will be relieved that AO World has broken into profitability. The company was generating losses five years ago, but has managed to turn it around and as we saw earlier is now earning 18%, which is always encouraging. On top of that, what's interesting is that the amount of capital being employed has remained steady, so the business hasn't needed to put any additional money to work to generate these higher returns. That being said, while an increase in efficiency is no doubt appealing, it'd be helpful to know if the company does have any investment plans going forward. After all, a company can only become a long term multi-bagger if it continually reinvests in itself at high rates of return.
On a separate but related note, it's important to know that AO World has a current liabilities to total assets ratio of 55%, which we'd consider pretty high. This can bring about some risks because the company is basically operating with a rather large reliance on its suppliers or other sorts of short-term creditors. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.