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There are a few key trends to look for if we want to identify the next multi-bagger. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. However, after investigating Ricardo (LON:RCDO), we don't think it's current trends fit the mold of a multi-bagger.
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 Ricardo is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.11 = UK£35m ÷ (UK£429m - UK£125m) (Based on the trailing twelve months to June 2024).
Therefore, Ricardo has an ROCE of 11%. In isolation, that's a pretty standard return but against the Professional Services industry average of 17%, it's not as good.
See our latest analysis for Ricardo
In the above chart we have measured Ricardo'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 Ricardo for free.
How Are Returns Trending?
Over the past five years, Ricardo's ROCE and capital employed have both remained mostly flat. It's not uncommon to see this when looking at a mature and stable business that isn't re-investing its earnings because it has likely passed that phase of the business cycle. So don't be surprised if Ricardo doesn't end up being a multi-bagger in a few years time. This probably explains why Ricardo is paying out 35% of its income to shareholders in the form of dividends. Unless businesses have highly compelling growth opportunities, they'll typically return some money to shareholders.
The Bottom Line On Ricardo's ROCE
In summary, Ricardo isn't compounding its earnings but is generating stable returns on the same amount of capital employed. Since the stock has declined 37% over the last five years, investors may not be too optimistic on this trend improving either. On the whole, we aren't too inspired by the underlying trends and we think there may be better chances of finding a multi-bagger elsewhere.
One more thing, we've spotted 2 warning signs facing Ricardo that you might find interesting.
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.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.