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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. Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base 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. That's why when we briefly looked at SDI's (ASX:SDI) ROCE trend, we were pretty happy with what we saw.
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. Analysts use this formula to calculate it for SDI:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.16 = AU$13m ÷ (AU$98m - AU$15m) (Based on the trailing twelve months to June 2021).
Therefore, SDI has an ROCE of 16%. In absolute terms, that's a pretty normal return, and it's somewhat close to the Medical Equipment industry average of 15%.
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 SDI's past further, check out this free graph of past earnings, revenue and cash flow.
What Does the ROCE Trend For SDI Tell Us?
While the returns on capital are good, they haven't moved much. The company has employed 22% more capital in the last five years, and the returns on that capital have remained stable at 16%. Since 16% is a moderate ROCE though, it's good to see a business can continue to reinvest at these decent rates of return. Over long periods of time, returns like these might not be too exciting, but with consistency they can pay off in terms of share price returns.
The Bottom Line
The main thing to remember is that SDI has proven its ability to continually reinvest at respectable rates of return. In light of this, the stock has only gained 35% over the last five years for shareholders who have owned the stock in this period. That's why it could be worth your time looking into this stock further to discover if it has more traits of a multi-bagger.
On a separate note, we've found 2 warning signs for SDI you'll probably want to know about.
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. 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.
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