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There are a few key trends to look for if we want to identify the next multi-bagger. Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base of capital employed. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. In light of that, when we looked at Eaton (NYSE:ETN) and its ROCE trend, we weren't exactly thrilled.
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. The formula for this calculation on Eaton is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.08 = US$2.0b ÷ (US$30b - US$5.5b) (Based on the trailing twelve months to June 2020).
So, Eaton has an ROCE of 8.0%. In absolute terms, that's a low return but it's around the Electrical industry average of 9.2%.
In the above chart we have measured Eaton's prior ROCE against its prior performance, but the future is arguably more important. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Eaton.
So How Is Eaton's ROCE Trending?
Things have been pretty stable at Eaton, with its capital employed and returns on that capital staying somewhat the same for the last five years. This tells us the company isn't reinvesting in itself, so it's plausible that it's past the growth phase. So don't be surprised if Eaton doesn't end up being a multi-bagger in a few years time. This probably explains why Eaton is paying out 52% of its income to shareholders in the form of dividends. Given the business isn't reinvesting in itself, it makes sense to distribute a portion of earnings among shareholders.
The Bottom Line On Eaton's ROCE
In summary, Eaton isn't compounding its earnings but is generating stable returns on the same amount of capital employed. Investors must think there's better things to come because the stock has knocked it out of the park delivering a 146% 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 Eaton, you might be interested to know about the 2 warning signs that our analysis has discovered.
While Eaton 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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