To find a multi-bagger stock, what are the underlying trends we should look for in a business? Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, 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. Having said that, from a first glance at Electronic Arts (NASDAQ:EA) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.
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 Electronic Arts is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.17 = US$1.5b ÷ (US$11b - US$2.6b) (Based on the trailing twelve months to June 2020).
Therefore, Electronic Arts has an ROCE of 17%. In absolute terms, that's a pretty normal return, and it's somewhat close to the Entertainment industry average of 15%.
Above you can see how the current ROCE for Electronic Arts 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 Electronic Arts.
What Does the ROCE Trend For Electronic Arts Tell Us?
On the surface, the trend of ROCE at Electronic Arts doesn't inspire confidence. To be more specific, ROCE has fallen from 30% over the last five years. 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.
On a related note, Electronic Arts has decreased its current liabilities to 23% of total assets. So we could link some of this to the decrease in ROCE. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Electronic Arts. And the stock has followed suit returning a meaningful 89% to shareholders over the last five years. So while the underlying trends could already be accounted for by investors, we still think this stock is worth looking into further.
On a final note, we've found 1 warning sign for Electronic Arts that we think you should be aware of.
While Electronic Arts may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.
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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