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. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. However, after briefly looking over the numbers, we don't think Alta Equipment Group (NYSE:ALTG) has the makings of a multi-bagger going forward, but let's have a look at why that may be.
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 Alta Equipment Group is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.016 = US$4.9m ÷ (US$745m - US$440m) (Based on the trailing twelve months to March 2021).
Therefore, Alta Equipment Group has an ROCE of 1.6%. In absolute terms, that's a low return and it also under-performs the Trade Distributors industry average of 11%.
In the above chart we have measured Alta Equipment Group's 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 Alta Equipment Group here for free.
What Does the ROCE Trend For Alta Equipment Group Tell Us?
On the surface, the trend of ROCE at Alta Equipment Group doesn't inspire confidence. To be more specific, ROCE has fallen from 17% over the last three years. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. If these investments prove successful, this can bode very well for long term stock performance.
On a side note, Alta Equipment Group has done well to pay down its current liabilities to 59% of total assets. That could partly explain why the ROCE has dropped. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money. Either way, they're still at a pretty high level, so we'd like to see them fall further if possible.
What We Can Learn From Alta Equipment Group's ROCE
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Alta Equipment Group. Furthermore the stock has climbed 62% over the last year, it would appear that investors are upbeat about the future. So while the underlying trends could already be accounted for by investors, we still think this stock is worth looking into further.
One more thing to note, we've identified 2 warning signs with Alta Equipment Group and understanding them should be part of your investment process.
While Alta Equipment Group 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.
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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