If you’re not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out for. Firstly, we’ll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base 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. 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)
0.10 = US$2.8b ÷ (US$34b – US$6.7b) (Based on the trailing twelve months to September 2022).
Therefore, Eaton has an ROCE of 10%. By itself that’s a normal return on capital and it’s in line with the industry’s average returns of 10%.
View our latest analysis for Eaton
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.
The Trend Of ROCE
There hasn’t been much to report for Eaton’s returns and its level of capital employed because both metrics have been steady for the past five years. It’s not uncommon to see this when looking at a mature and stable business that isn’t re-investing its earnings because it has likely passed that phase of the business cycle. So don’t be surprised if Eaton doesn’t end up being a multi-bagger in a few years time. With fewer investment opportunities, it makes sense that Eaton has been paying out a decent 43% of its earnings to shareholders. Given the business isn’t reinvesting in itself, it makes sense to distribute a portion of earnings among shareholders.
What We Can Learn From 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 122% gain to shareholders who have held over the last five years. However, unless these underlying trends turn more positive, we wouldn’t get our hopes up too high.
One more thing, we’ve spotted 2 warning signs facing Eaton that you might find interesting.
If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive returns on equity.
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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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