If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? 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. However, after investigating RH (NYSE:RH), we don't think it's current trends fit the mold of a multi-bagger.
Understanding Return On Capital Employed (ROCE)
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. Analysts use this formula to calculate it for RH:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.078 = US$261m ÷ (US$4.4b - US$1.0b) (Based on the trailing twelve months to August 2024).
Therefore, RH has an ROCE of 7.8%. Ultimately, that's a low return and it under-performs the Specialty Retail industry average of 12%.
Above you can see how the current ROCE for RH 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 RH for free.
The Trend Of ROCE
On the surface, the trend of ROCE at RH doesn't inspire confidence. Over the last five years, returns on capital have decreased to 7.8% from 23% five years ago. However it looks like RH 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 may take some time before the company starts to see any change in earnings from these investments.
On a related note, RH has decreased its current liabilities to 23% of total assets. That could partly explain why the ROCE has dropped. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.
The Bottom Line
Bringing it all together, while we're somewhat encouraged by RH's reinvestment in its own business, we're aware that returns are shrinking. Although the market must be expecting these trends to improve because the stock has gained 79% 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 identified 5 warning signs with RH (at least 2 which make us uncomfortable) , and understanding them would certainly be useful.
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.
