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What are the early trends we should look for to identify a stock that could multiply in value over the long term? Amongst other things, we'll want to see two things; firstly, a growing return on capital employed (ROCE) and secondly, an expansion in the company's amount of capital employed. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. Looking at REA Group (ASX:REA), it does have a high ROCE right now, but lets see how returns are trending.
Return On Capital Employed (ROCE): What Is It?
If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Analysts use this formula to calculate it for REA Group:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.26 = AU$622m ÷ (AU$2.7b - AU$321m) (Based on the trailing twelve months to December 2023).
So, REA Group has an ROCE of 26%. In absolute terms that's a great return and it's even better than the Interactive Media and Services industry average of 8.0%.
View our latest analysis for REA Group
In the above chart we have measured REA Group's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering REA Group for free.
What Can We Tell From REA Group's ROCE Trend?
On the surface, the trend of ROCE at REA Group doesn't inspire confidence. Historically returns on capital were even higher at 41%, but they have dropped over the last five years. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It may take some time before the company starts to see any change in earnings from these investments.
On a side note, REA Group has done well to pay down its current liabilities to 12% of total assets. That could partly explain why the ROCE has dropped. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.
The Bottom Line On REA Group's ROCE
In summary, REA Group is reinvesting funds back into the business for growth but unfortunately it looks like sales haven't increased much just yet. Yet to long term shareholders the stock has gifted them an incredible 111% 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.