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What trends should we look for it we want to identify stocks that can 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. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. So on that note, Luna Innovations (NASDAQ:LUNA) looks quite promising in regards to its trends of return on capital.
What is 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 Luna Innovations:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.066 = US$6.6m ÷ (US$129m - US$27m) (Based on the trailing twelve months to March 2021).
Therefore, Luna Innovations has an ROCE of 6.6%. In absolute terms, that's a low return and it also under-performs the Electronic industry average of 9.7%.
Above you can see how the current ROCE for Luna Innovations 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 Luna Innovations.
What Does the ROCE Trend For Luna Innovations Tell Us?
Luna Innovations has recently broken into profitability so their prior investments seem to be paying off. The company was generating losses five years ago, but now it's earning 6.6% which is a sight for sore eyes. In addition to that, Luna Innovations is employing 146% 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.
The Bottom Line
Overall, Luna Innovations gets a big tick from us thanks in most part to the fact that it is now profitable and is reinvesting in its business. And a remarkable 801% total return over the last five years tells us that investors are expecting more good things to come in the future. With that being said, we still think the promising fundamentals mean the company deserves some further due diligence.
One more thing to note, we've identified 2 warning signs with Luna Innovations and understanding these should be part of your investment process.
While Luna Innovations 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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