There are a few key trends to look for if we want to identify the next multi-bagger. Amongst other things, we'll want to see two things; firstly, a growing return on capital employed (ROCE) and secondly, an expansion in the company's amount 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. Having said that, from a first glance at Compass Group (LON:CPG) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper 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. Analysts use this formula to calculate it for Compass Group:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.14 = UK£1.6b ÷ (UK£19b - UK£7.0b) (Based on the trailing twelve months to September 2022).
Thus, Compass Group has an ROCE of 14%. On its own, that's a standard return, however it's much better than the 6.5% generated by the Hospitality industry.
In the above chart we have measured Compass Group'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 Compass Group.
How Are Returns Trending?
When we looked at the ROCE trend at Compass Group, we didn't gain much confidence. Over the last five years, returns on capital have decreased to 14% from 24% five years ago. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.
The Key Takeaway
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Compass Group. These trends are starting to be recognized by investors since the stock has delivered a 35% gain to shareholders who've held over the last five years. So this stock may still be an appealing investment opportunity, if other fundamentals prove to be sound.
Compass Group does have some risks though, and we've spotted 1 warning sign for Compass Group that you might be interested in.
While Compass Group isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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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