If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing amount 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. Although, when we looked at Samuel Heath & Sons (LON:HSM), it didn't seem to tick all of these boxes.
Understanding 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. Analysts use this formula to calculate it for Samuel Heath & Sons:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.031 = UK£368k ÷ (UK£14m - UK£1.9m) (Based on the trailing twelve months to September 2020).
So, Samuel Heath & Sons has an ROCE of 3.1%. Ultimately, that's a low return and it under-performs the Building industry average of 5.3%.
While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you're interested in investigating Samuel Heath & Sons' past further, check out this free graph of past earnings, revenue and cash flow.
What The Trend Of ROCE Can Tell Us
When we looked at the ROCE trend at Samuel Heath & Sons, we didn't gain much confidence. Around five years ago the returns on capital were 11%, but since then they've fallen to 3.1%. And considering revenue has dropped while employing more capital, we'd be cautious. This could mean that the business is losing its competitive advantage or market share, because while more money is being put into ventures, it's actually producing a lower return - "less bang for their buck" per se.
Our Take On Samuel Heath & Sons' ROCE
From the above analysis, we find it rather worrisome that returns on capital and sales for Samuel Heath & Sons have fallen, meanwhile the business is employing more capital than it was five years ago. Investors must expect better things on the horizon though because the stock has risen 37% in the last five years. Either way, we aren't huge fans of the current trends and so with that we think you might find better investments elsewhere.
Since virtually every company faces some risks, it's worth knowing what they are, and we've spotted 4 warning signs for Samuel Heath & Sons (of which 1 shouldn't be ignored!) that you should know about.
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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