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To find a multi-bagger stock, what are the underlying trends we should look for in a business? In a perfect world, we'd like to see a company investing more capital into its business and ideally the returns earned from that capital are also increasing. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. So when we looked at Cairn Energy (LON:CNE) and its trend of ROCE, we really liked what we saw.
What is 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 Cairn Energy is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.13 = US$234m ÷ (US$2.1b - US$234m) (Based on the trailing twelve months to December 2019).
Thus, Cairn Energy has an ROCE of 13%. In absolute terms, that's a satisfactory return, but compared to the Oil and Gas industry average of 6.1% it's much better.
Check out our latest analysis for Cairn Energy
In the above chart we have measured Cairn Energy's 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.
The Trend Of ROCE
Like most people, we're pleased that Cairn Energy is now generating some pretax earnings. While the business is profitable now, it used to be incurring losses on invested capital five years ago. Additionally, the business is utilizing 32% less capital than it was five years ago, and taken at face value, that can mean the company needs less funds at work to get a return. The reduction could indicate that the company is selling some assets, and considering returns are up, they appear to be selling the right ones.
In Conclusion...
From what we've seen above, Cairn Energy has managed to increase it's returns on capital all the while reducing it's capital base. Since the total return from the stock has been almost flat over the last five years, there might be an opportunity here if the valuation looks good. So researching this company further and determining whether or not these trends will continue seems justified.
One more thing: We've identified 2 warning signs with Cairn Energy (at least 1 which can't be ignored) , and understanding them would certainly be useful.
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.
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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