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Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. 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. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. With that in mind, we've noticed some promising trends at British American Tobacco (LON:BATS) so let's look a bit deeper.
Return On Capital Employed (ROCE): What Is It?
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. The formula for this calculation on British American Tobacco is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.12 = UK£13b ÷ (UK£119b - UK£16b) (Based on the trailing twelve months to December 2023).
Therefore, British American Tobacco has an ROCE of 12%. In absolute terms, that's a pretty standard return but compared to the Tobacco industry average it falls behind.
View our latest analysis for British American Tobacco
Above you can see how the current ROCE for British American Tobacco compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free analyst report for British American Tobacco .
So How Is British American Tobacco's ROCE Trending?
British American Tobacco has not disappointed in regards to ROCE growth. We found that the returns on capital employed over the last five years have risen by 59%. That's not bad because this tells for every dollar invested (capital employed), the company is increasing the amount earned from that dollar. Interestingly, the business may be becoming more efficient because it's applying 21% less capital than it was five years ago. A business that's shrinking its asset base like this isn't usually typical of a soon to be multi-bagger company.
Our Take On British American Tobacco's ROCE
In the end, British American Tobacco has proven it's capital allocation skills are good with those higher returns from less amount of capital. Since the stock has only returned 26% to shareholders over the last five years, the promising fundamentals may not be recognized yet by investors. So exploring more about this stock could uncover a good opportunity, if the valuation and other metrics stack up.