If you're looking for a multi-bagger, there's a few things to keep an eye out for. Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base of capital employed. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. In light of that, when we looked at CarMax (NYSE:KMX) and its ROCE trend, we weren't exactly thrilled.
What is Return On Capital Employed (ROCE)?
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 CarMax, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.046 = US$861m ÷ (US$20b - US$1.2b) (Based on the trailing twelve months to May 2020).
So, CarMax has an ROCE of 4.6%. In absolute terms, that's a low return and it also under-performs the Specialty Retail industry average of 9.2%.
In the above chart we have measured CarMax'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 CarMax here for free.
How Are Returns Trending?
When we looked at the ROCE trend at CarMax, we didn't gain much confidence. Around five years ago the returns on capital were 7.9%, but since then they've fallen to 4.6%. However it looks like CarMax 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's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.
Bringing it all together, while we're somewhat encouraged by CarMax's reinvestment in its own business, we're aware that returns are shrinking. 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 identified 3 warning signs with CarMax (at least 1 which doesn't sit too well with us) , and understanding these would certainly be useful.
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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