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. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. So when we looked at AA (LON:AA.), they do have a high ROCE, but we weren't exactly elated from how returns are trending.
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 AA, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.21 = UK£252m ÷ (UK£1.9b - UK£734m) (Based on the trailing twelve months to January 2020).
So, AA has an ROCE of 21%. In absolute terms that's a great return and it's even better than the Consumer Services industry average of 11%.
Above you can see how the current ROCE for AA 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 AA.
The Trend Of ROCE
There hasn't been much to report for AA's returns and its level of capital employed because both metrics have been steady for the past five years. Businesses with these traits tend to be mature and steady operations because they're past the growth phase. So it may not be a multi-bagger in the making, but given the decent 21% return on capital, it'd be difficult to find fault with the business's current operations.
On another note, while the change in ROCE trend might not scream for attention, it's interesting that the current liabilities have actually gone up over the last five years. This is intriguing because if current liabilities hadn't increased to 38% of total assets, this reported ROCE would probably be less than21% because total capital employed would be higher.The 21% ROCE could be even lower if current liabilities weren't 38% of total assets, because the the formula would show a larger base of total capital employed. With that in mind, just be wary if this ratio increases in the future, because if it gets particularly high, this brings with it some new elements of risk.
While AA has impressive profitability from its capital, it isn't increasing that amount of capital. Moreover, since the stock has crumbled 93% over the last five years, it appears investors are expecting the worst. All in all, the inherent trends aren't typical of multi-baggers, so if that's what you're after, we think you might have more luck elsewhere.
On a final note, we found 2 warning signs for AA (1 doesn't sit too well with us) you should be aware of.
High returns are a key ingredient to strong performance, so check out our free list ofstocks 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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email email@example.com.