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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? 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. 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 Lechwerke (FRA:LEC) 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)
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. To calculate this metric for Lechwerke, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.049 = €30m ÷ (€1.7b - €1.1b) (Based on the trailing twelve months to June 2022).
So, Lechwerke has an ROCE of 4.9%. Ultimately, that's a low return and it under-performs the Electric Utilities industry average of 8.4%.
See our latest analysis for Lechwerke
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're interested in investigating Lechwerke's past further, check out this free graph of past earnings, revenue and cash flow.
The Trend Of ROCE
We're a bit concerned with the trends, because the business is applying 62% less capital than it was five years ago and returns on that capital have stayed flat. This indicates to us that assets are being sold and thus the business is likely shrinking, which you'll remember isn't the typical ingredients for an up-and-coming multi-bagger. In addition to that, since the ROCE doesn't scream "quality" at 4.9%, it's hard to get excited about these developments.
Another point to note, we noticed the company has increased current liabilities over the last five years. This is intriguing because if current liabilities hadn't increased to 65% of total assets, this reported ROCE would probably be less than4.9% because total capital employed would be higher.The 4.9% ROCE could be even lower if current liabilities weren't 65% of total assets, because the the formula would show a larger base of total capital employed. Additionally, this high level of current liabilities isn't ideal because it means the company's suppliers (or short-term creditors) are effectively funding a large portion of the business.