Returns On Capital At REA Group (ASX:REA) Paint A Concerning Picture
If we want to find a stock that could multiply over the long term, what are the underlying trends we should look 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. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. So while REA Group (ASX:REA) has a high ROCE right now, lets see what we can decipher from how returns are changing.
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 REA Group, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.31 = AU$414m ÷ (AU$1.7b - AU$415m) (Based on the trailing twelve months to December 2020).
Thus, REA Group has an ROCE of 31%. That's a fantastic return and not only that, it outpaces the average of 13% earned by companies in a similar industry.
Check out our latest analysis for REA Group
Above you can see how the current ROCE for REA Group compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.
How Are Returns Trending?
On the surface, the trend of ROCE at REA Group doesn't inspire confidence. Historically returns on capital were even higher at 45%, but they have dropped over the last five years. However it looks like REA Group 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.
While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 24%, which has impacted the ROCE. Without this increase, it's likely that ROCE would be even lower than 31%. Keep an eye on this ratio, because the business could encounter some new risks if this metric gets too high.
The Bottom Line
Bringing it all together, while we're somewhat encouraged by REA Group's reinvestment in its own business, we're aware that returns are shrinking. Investors must think there's better things to come because the stock has knocked it out of the park, delivering a 238% gain to shareholders who have held over the last five years. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.
If you want to continue researching REA Group, you might be interested to know about the 2 warning signs that our analysis has discovered.
High returns are a key ingredient to strong performance, so check out our free list ofstocks 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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
