To find a multi-bagger stock, what are the underlying trends we should look for in a business? In a perfect world, we'd like to see a company investing more capital into its business and ideally the returns earned from that capital are also increasing. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. So when we looked at Rolls-Royce Holdings (LON:RR.) and its trend of ROCE, we really liked 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 Rolls-Royce Holdings is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.038 = UK£645m ÷ (UK£31b - UK£14b) (Based on the trailing twelve months to June 2022).
Therefore, Rolls-Royce Holdings has an ROCE of 3.8%. In absolute terms, that's a low return and it also under-performs the Aerospace & Defense industry average of 9.6%.
In the above chart we have measured Rolls-Royce Holdings' 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 Rolls-Royce Holdings here for free.
How Are Returns Trending?
Even though ROCE is still low in absolute terms, it's good to see it's heading in the right direction. The figures show that over the last five years, ROCE has grown 1,148% whilst employing roughly the same amount of capital. So our take on this is that the business has increased efficiencies to generate these higher returns, all the while not needing to make any additional investments. On that front, things are looking good so it's worth exploring what management has said about growth plans going forward.
On a side note, Rolls-Royce Holdings' current liabilities are still rather high at 45% of total assets. This can bring about some risks because the company is basically operating with a rather large reliance on its suppliers or other sorts of short-term creditors. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.
What We Can Learn From Rolls-Royce Holdings' ROCE
To sum it up, Rolls-Royce Holdings is collecting higher returns from the same amount of capital, and that's impressive. Although the company may be facing some issues elsewhere since the stock has plunged 74% in the last five years. Regardless, we think the underlying fundamentals warrant this stock for further investigation.
On a final note, we've found 1 warning sign for Rolls-Royce Holdings that we think you should be aware of.
While Rolls-Royce Holdings may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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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