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. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding 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. However, after investigating Cochlear (ASX:COH), we don't think it's current trends fit the mold of a multi-bagger.
Understanding Return On Capital Employed (ROCE)
For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. To calculate this metric for Cochlear, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.18 = AU$378m ÷ (AU$2.4b - AU$378m) (Based on the trailing twelve months to December 2021).
Therefore, Cochlear has an ROCE of 18%. In absolute terms, that's a satisfactory return, but compared to the Medical Equipment industry average of 12% it's much better.
In the above chart we have measured Cochlear's prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.
What Does the ROCE Trend For Cochlear Tell Us?
On the surface, the trend of ROCE at Cochlear doesn't inspire confidence. Around five years ago the returns on capital were 39%, but since then they've fallen to 18%. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. If these investments prove successful, this can bode very well for long term stock performance.
What We Can Learn From Cochlear's ROCE
In summary, despite lower returns in the short term, we're encouraged to see that Cochlear is reinvesting for growth and has higher sales as a result. In light of this, the stock has only gained 35% over the last five years. So this stock may still be an appealing investment opportunity, if other fundamentals prove to be sound.
If you're still interested in Cochlear it's worth checking out our FREE intrinsic value approximation to see if it's trading at an attractive price in other respects.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high 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.