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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. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. In light of that, when we looked at Otter Tail (NASDAQ:OTTR) and its ROCE trend, we weren't exactly thrilled.
What is Return On Capital Employed (ROCE)?
For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. To calculate this metric for Otter Tail, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.061 = US$132m ÷ (US$2.4b - US$233m) (Based on the trailing twelve months to June 2020).
Thus, Otter Tail has an ROCE of 6.1%. On its own that's a low return, but compared to the average of 4.7% generated by the Electric Utilities industry, it's much better.
In the above chart we have a measured Otter Tail's prior ROCE against its prior performance, but the future is arguably more important. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Otter Tail.
What Does the ROCE Trend For Otter Tail Tell Us?
The returns on capital haven't changed much for Otter Tail in recent years. The company has consistently earned 6.1% for the last five years, and the capital employed within the business has risen 34% in that time. This poor ROCE doesn't inspire confidence right now, and with the increase in capital employed, it's evident that the business isn't deploying the funds into high return investments.
The Bottom Line
Long story short, while Otter Tail has been reinvesting its capital, the returns that it's generating haven't increased. Since the stock has gained an impressive 75% over the last five years, investors must think there's better things to come. 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 Otter Tail that you might find interesting.
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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