What are the early trends we should look for to identify a stock that could multiply in value over the long term? Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing 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 IPG Photonics (NASDAQ:IPGP), 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 IPG Photonics:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.082 = US$211m ÷ (US$2.8b - US$195m) (Based on the trailing twelve months to June 2020).
Therefore, IPG Photonics has an ROCE of 8.2%. In absolute terms, that's a low return but it's around the Electronic industry average of 10%.
In the above chart we have measured IPG Photonics' prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering IPG Photonics here for free.
What Does the ROCE Trend For IPG Photonics Tell Us?
In terms of IPG Photonics' historical ROCE movements, the trend isn't fantastic. To be more specific, ROCE has fallen from 26% over the last five years. And considering revenue has dropped while employing more capital, we'd be cautious. If this were to continue, you might be looking at a company that is trying to reinvest for growth but is actually losing market share since sales haven't increased.
In summary, we're somewhat concerned by IPG Photonics' diminishing returns on increasing amounts of capital. Since the stock has skyrocketed 113% over the last five years, it looks like investors have high expectations of the stock. Regardless, we don't feel to comfortable with the fundamentals so we'd be steering clear of this stock for now.
IPG Photonics does have some risks though, and we've spotted 2 warning signs for IPG Photonics that you might be interested in.
While IPG Photonics 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.
This article by Simply Wall St is general in nature. 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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