If we want to find a stock that could multiply over the long term, what are the underlying trends we should be looking for? First, we’ll want to see proof come back on capital employed (ROCE) which is increasing, and on the other hand, a base capital employed. Simply put, these types of businesses are slot machines, meaning they continually reinvest their profits at ever-higher rates of return. So when we looked at the ROCE trend of A. O. Smith (NYSE: AOS) we really liked what we saw.
Return on capital employed (ROCE): what is it?
For those who don’t know what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital used in its business. The formula for this calculation on AO Smith is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
0.26 = $642 million ÷ ($3.4 billion – $1.0 billion) (Based on the last twelve months to March 2022).
Therefore, AO Smith has a ROCE of 26%. This is a fantastic return and not only that, it exceeds the 14% average earned by companies in a similar industry.
See our latest analysis for AO Smith
In the chart above, we measured AO Smith’s past ROCE against its past performance, but the future is arguably more important. If you want to see what analysts predict for the future, you should check out our free report for AO Smith.
What does the ROCE trend tell us for AO Smith?
AO Smith is promising given that his ROCE is up and to the right. Looking at the data, we can see that even though the capital employed in the company has remained relatively stable, the ROCE generated has increased by 23% over the last five years. Basically, the business generates higher returns from the same amount of capital and this is evidence that there are improvements in the efficiency of the business. The company is doing well in this direction, and it is worth examining what the management team has planned for the long-term growth prospects.
What we can learn from AO Smith’s ROCE
As noted above, AO Smith appears to be becoming more efficient at generating returns as capital employed has remained flat but earnings (before interest and taxes) are up. Given that the stock has only returned 9.1% to shareholders over the past five years, the promising fundamentals may not yet be recognized by investors. Given this, we would take a closer look at this stock in case it has more traits that can make it multiply in the long run.
If you want to know the risks that AO Smith faces, we have discovered 1 warning sign of which you should be aware.
If you want to see other businesses earning high returns, check out our free list of companies earning high returns with strong balance sheets here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.