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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? One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing amount of capital employed. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. So when we looked at Savannah Energy (LON:SAVE) and its trend of ROCE, we really liked what we saw.
What is 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. To calculate this metric for Savannah Energy, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.046 = US$43m ÷ (US$1.2b - US$231m) (Based on the trailing twelve months to June 2020).
So, Savannah Energy has an ROCE of 4.6%. On its own that's a low return on capital but it's in line with the industry's average returns of 5.1%.
Above you can see how the current ROCE for Savannah Energy compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Savannah Energy.
What The Trend Of ROCE Can Tell Us
We're delighted to see that Savannah Energy is reaping rewards from its investments and is now generating some pre-tax profits. The company was generating losses five years ago, but now it's earning 4.6% which is a sight for sore eyes. In addition to that, Savannah Energy is employing 1,165% more capital than previously which is expected of a company that's trying to break into profitability. This can tell us that the company has plenty of reinvestment opportunities that are able to generate higher returns.
On a side note, we noticed that the improvement in ROCE appears to be partly fueled by an increase in current liabilities. The current liabilities has increased to 20% of total assets, so the business is now more funded by the likes of its suppliers or short-term creditors. It's worth keeping an eye on this because as the percentage of current liabilities to total assets increases, some aspects of risk also increase.
What We Can Learn From Savannah Energy's ROCE
Overall, Savannah Energy gets a big tick from us thanks in most part to the fact that it is now profitable and is reinvesting in its business. Although the company may be facing some issues elsewhere since the stock has plunged 71% in the last five years. Regardless, we think the underlying fundamentals warrant this stock for further investigation.
Like most companies, Savannah Energy does come with some risks, and we've found 2 warning signs that you should be aware of.
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. 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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