To find a multi-bagger stock, what are the underlying trends we should look for in a business? Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base 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. So when we looked at Energy Resources of Australia (ASX:ERA) and its trend of ROCE, we really liked what we saw.
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. To calculate this metric for Energy Resources of Australia, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
0.013 = AU$9.7m ÷ (AU$1.0b – AU$229m) (Based on the trailing twelve months to December 2020).
So, Energy Resources of Australia has an ROCE of 1.3%. Even though it's in line with the industry average of 1.3%, it's still a low return by itself.
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 Energy Resources of Australia's past further, check out this free graph of past earnings, revenue and cash flow.
The Trend Of ROCE
Like most people, we're pleased that Energy Resources of Australia is now generating some pretax earnings. Historically the company was generating losses but as we can see from the latest figures referenced above, they're now earning 1.3% on their capital employed. At first glance, it seems the business is getting more proficient at generating returns, because over the same period, the amount of capital employed has reduced by 20%. This could potentially mean that the company is selling some of its assets.
For the record though, there was a noticeable increase in the company's current liabilities over the period, so we would attribute some of the ROCE growth to that. Essentially the business now has suppliers or short-term creditors funding about 23% of its operations, which isn't ideal. It's worth keeping an eye on this because as the percentage of current liabilities to total assets increases, some aspects of risk also increase.
The Bottom Line On Energy Resources of Australia's ROCE
In summary, it's great to see that Energy Resources of Australia has been able to turn things around and earn higher returns on lower amounts of capital. Given the stock has declined 12% in the last five years, this could be a good investment if the valuation and other metrics are also appealing. With that in mind, we believe the promising trends warrant this stock for further investigation.
One more thing to note, we've identified 1 warning sign with Energy Resources of Australia and understanding it should be part of your investment process.
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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