If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base of capital employed. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. That's why when we briefly looked at Tree Island Steel's (TSE:TSL) ROCE trend, we were very happy with what we saw.
Understanding Return On Capital Employed (ROCE)
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 Tree Island Steel is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.20 = CA$29m ÷ (CA$172m - CA$30m) (Based on the trailing twelve months to June 2021).
So, Tree Island Steel has an ROCE of 20%. That's a fantastic return and not only that, it outpaces the average of 4.1% earned by companies in a similar industry.
Historical performance is a great place to start when researching a stock so above you can see the gauge for Tree Island Steel's ROCE against it's prior returns. If you're interested in investigating Tree Island Steel's past further, check out this free graph of past earnings, revenue and cash flow.
What Can We Tell From Tree Island Steel's ROCE Trend?
We'd be pretty happy with returns on capital like Tree Island Steel. The company has consistently earned 20% for the last five years, and the capital employed within the business has risen 63% in that time. With returns that high, it's great that the business can continually reinvest its money at such appealing rates of return. If these trends can continue, it wouldn't surprise us if the company became a multi-bagger.
One more thing to note, even though ROCE has remained relatively flat over the last five years, the reduction in current liabilities to 17% of total assets, is good to see from a business owner's perspective. This can eliminate some of the risks inherent in the operations because the business has less outstanding obligations to their suppliers and or short-term creditors than they did previously.
What We Can Learn From Tree Island Steel's ROCE
In short, we'd argue Tree Island Steel has the makings of a multi-bagger since its been able to compound its capital at very profitable rates of return. Despite the good fundamentals, total returns from the stock have been virtually flat over the last five years. For that reason, savvy investors might want to look further into this company in case it's a prime investment.
One more thing: We've identified 4 warning signs with Tree Island Steel (at least 2 which make us uncomfortable) , and understanding these would certainly be useful.
Tree Island Steel is not the only stock earning high returns. If you'd like to see more, check out our free list of companies earning high returns on equity with solid fundamentals.
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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