What trends should we look for it we want to identify stocks that can multiply in value over the long term? 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. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. So when we looked at L.S. Starrett (NYSE:SCX) and its trend of ROCE, we really liked what we saw.
Return On Capital Employed (ROCE): What is it?
For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. To calculate this metric for L.S. Starrett, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.14 = US$19m ÷ (US$190m - US$56m) (Based on the trailing twelve months to September 2021).
Therefore, L.S. Starrett has an ROCE of 14%. On its own, that's a standard return, however it's much better than the 10% generated by the Machinery industry.
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 L.S. Starrett's past further, check out this free graph of past earnings, revenue and cash flow.
How Are Returns Trending?
We're delighted to see that L.S. Starrett is reaping rewards from its investments and has now broken into profitability. Historically the company was generating losses but as we can see from the latest figures referenced above, they're now earning 14% on their capital employed. At first glance, it seems the business is getting more proficient at generating returns, because over the same period, the amount of capital employed has reduced by 25%. L.S. Starrett could be selling under-performing assets since the ROCE is improving.
On a side note, we noticed that the improvement in ROCE appears to be partly fueled by an increase in current liabilities. The current liabilities has increased to 30% of total assets, so the business is now more funded by the likes of its suppliers or short-term creditors. It's worth keeping an eye on this because as the percentage of current liabilities to total assets increases, some aspects of risk also increase.
Our Take On L.S. Starrett's ROCE
From what we've seen above, L.S. Starrett has managed to increase it's returns on capital all the while reducing it's capital base. And given the stock has remained rather flat over the last five years, there might be an opportunity here if other metrics are strong. That being the case, research into the company's current valuation metrics and future prospects seems fitting.
One more thing: We've identified 5 warning signs with L.S. Starrett (at least 1 which doesn't sit too well with us) , and understanding them would certainly be useful.
While L.S. Starrett 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.
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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.