If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. In a perfect world, we'd like to see a company investing more capital into its business and ideally the returns earned from that capital are also increasing. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. So when we looked at Nick Scali (ASX:NCK), they do have a high ROCE, but we weren't exactly elated from how returns are trending.
Understanding Return On Capital Employed (ROCE)
Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. To calculate this metric for Nick Scali, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.24 = AU$63m ÷ (AU$365m - AU$98m) (Based on the trailing twelve months to June 2020).
Thus, Nick Scali has an ROCE of 24%. In absolute terms that's a great return and it's even better than the Specialty Retail industry average of 16%.
Above you can see how the current ROCE for Nick Scali 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 Nick Scali here for free.
What The Trend Of ROCE Can Tell Us
When we looked at the ROCE trend at Nick Scali, we didn't gain much confidence. While it's comforting that the ROCE is high, five years ago it was 38%. However it looks like Nick Scali 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.
The Key Takeaway
Bringing it all together, while we're somewhat encouraged by Nick Scali's reinvestment in its own business, we're aware that returns are shrinking. Yet to long term shareholders the stock has gifted them an incredible 163% return in the last five years, so the market appears to be rosy about its future. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.
On a separate note, we've found 2 warning signs for Nick Scali you'll probably want to 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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