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What are the early trends we should look for to identify a stock that could multiply in value over the long term? Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base of capital employed. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. Although, when we looked at A. O. Smith (NYSE:AOS), it didn't seem to tick all of these boxes.
Understanding 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 A. O. Smith:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.19 = US$404m ÷ (US$3.0b - US$806m) (Based on the trailing twelve months to September 2020).
Thus, A. O. Smith has an ROCE of 19%. In absolute terms, that's a satisfactory return, but compared to the Building industry average of 15% it's much better.
Above you can see how the current ROCE for A. O. Smith compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering A. O. Smith here for free.
What Can We Tell From A. O. Smith's ROCE Trend?
There hasn't been much to report for A. O. Smith's returns and its level of capital employed because both metrics have been steady for the past five years. It's not uncommon to see this when looking at a mature and stable business that isn't re-investing its earnings because it has likely passed that phase of the business cycle. So unless we see a substantial change at A. O. Smith in terms of ROCE and additional investments being made, we wouldn't hold our breath on it being a multi-bagger. With fewer investment opportunities, it makes sense that A. O. Smith has been paying out a decent 37% of its earnings to shareholders. Unless businesses have highly compelling growth opportunities, they'll typically return some money to shareholders.
The Key Takeaway
In a nutshell, A. O. Smith has been trudging along with the same returns from the same amount of capital over the last five years. Although the market must be expecting these trends to improve because the stock has gained 52% over the last five years. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.
One more thing, we've spotted 1 warning sign facing A. O. Smith that you might find interesting.
While A. O. Smith isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.
This article by Simply Wall St is general in nature. 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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