There are a few key trends to look for if we want to identify the next multi-bagger. 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 Potbelly (NASDAQ:PBPB), we don't think it's current trends fit the mold of a multi-bagger.
Understanding 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. The formula for this calculation on Potbelly is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.0054 = US$950k ÷ (US$245m - US$69m) (Based on the trailing twelve months to December 2022).
Therefore, Potbelly has an ROCE of 0.5%. Ultimately, that's a low return and it under-performs the Hospitality industry average of 9.8%.
Above you can see how the current ROCE for Potbelly compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Potbelly here for free.
What Does the ROCE Trend For Potbelly Tell Us?
On the surface, the trend of ROCE at Potbelly doesn't inspire confidence. Around five years ago the returns on capital were 8.0%, but since then they've fallen to 0.5%. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.
While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 28%, which has impacted the ROCE. Without this increase, it's likely that ROCE would be even lower than 0.5%. Keep an eye on this ratio, because the business could encounter some new risks if this metric gets too high.
The Bottom Line
In summary, despite lower returns in the short term, we're encouraged to see that Potbelly is reinvesting for growth and has higher sales as a result. However, despite the promising trends, the stock has fallen 18% over the last five years, so there might be an opportunity here for astute investors. As a result, we'd recommend researching this stock further to uncover what other fundamentals of the business can show us.
If you'd like to know about the risks facing Potbelly, we've discovered 2 warning signs that you should be aware of.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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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