Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing 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. Speaking of which, we noticed some great changes in Persimmon's (LON:PSN) returns on capital, so let's have a look.
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. To calculate this metric for Persimmon, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.29 = UK£1.0b ÷ (UK£4.5b - UK£996m) (Based on the trailing twelve months to December 2019).
Therefore, Persimmon has an ROCE of 29%. That's a fantastic return and not only that, it outpaces the average of 13% earned by companies in a similar industry.
Above you can see how the current ROCE for Persimmon 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 Persimmon here for free.
So How Is Persimmon's ROCE Trending?
The trends we've noticed at Persimmon are quite reassuring. The data shows that returns on capital have increased substantially over the last five years to 29%. Basically the business is earning more per dollar of capital invested and in addition to that, 38% more capital is being employed now too. The increasing returns on a growing amount of capital is common amongst multi-baggers and that's why we're impressed.
The Bottom Line
In summary, it's great to see that Persimmon can compound returns by consistently reinvesting capital at increasing rates of return, because these are some of the key ingredients of those highly sought after multi-baggers. Since the stock has returned a solid 65% to shareholders over the last five years, it's fair to say investors are beginning to recognize these changes. In light of that, we think it's worth looking further into this stock because if Persimmon can keep these trends up, it could have a bright future ahead.
Since virtually every company faces some risks, it's worth knowing what they are, and we've spotted 2 warning signs for Persimmon (of which 1 makes us a bit uncomfortable!) that you should know about.
If you want to search for more stocks that have been earning high returns, check out this free list of stocks with solid balance sheets that are also earning high 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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