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Here's What's Concerning About Rentokil Initial's (LON:RTO) Returns On Capital

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If you're looking for a multi-bagger, there's a few things to keep an eye out for. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. However, after investigating Rentokil Initial (LON:RTO), we don't think it's current trends fit the mold of a multi-bagger.

Return On Capital Employed (ROCE): What is it?

For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. To calculate this metric for Rentokil Initial, this is the formula:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.11 = UK£329m ÷ (UK£5.8b - UK£3.0b) (Based on the trailing twelve months to December 2020).

So, Rentokil Initial has an ROCE of 11%. That's a relatively normal return on capital, and it's around the 12% generated by the Commercial Services industry.

See our latest analysis for Rentokil Initial

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In the above chart we have measured Rentokil Initial'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 Rentokil Initial here for free.

How Are Returns Trending?

On the surface, the trend of ROCE at Rentokil Initial doesn't inspire confidence. To be more specific, ROCE has fallen from 16% over the last five years. However it looks like Rentokil Initial might be reinvesting for long term growth because while capital employed has increased, the company's sales haven't changed much in the last 12 months. It may take some time before the company starts to see any change in earnings from these investments.

On a side note, Rentokil Initial's current liabilities have increased over the last five years to 51% of total assets, effectively distorting the ROCE to some degree. Without this increase, it's likely that ROCE would be even lower than 11%. And with current liabilities at these levels, suppliers or short-term creditors are effectively funding a large part of the business, which can introduce some risks.

Our Take On Rentokil Initial's ROCE

Bringing it all together, while we're somewhat encouraged by Rentokil Initial's reinvestment in its own business, we're aware that returns are shrinking. Yet to long term shareholders the stock has gifted them an incredible 181% return in the last five years, so the market appears to be rosy about its future. But if the trajectory of these underlying trends continue, we think the likelihood of it being a multi-bagger from here isn't high.

On a final note, we found 2 warning signs for Rentokil Initial (1 is significant) 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.