Did you know there are some financial metrics that can provide clues of a potential multi-bagger? 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. Although, when we looked at Citadel Group (ASX:CGL), it didn't seem to tick all of these boxes.
Return On Capital Employed (ROCE): What is it?
Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. To calculate this metric for Citadel Group, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.015 = AU$4.5m ÷ (AU$337m - AU$45m) (Based on the trailing twelve months to June 2020).
So, Citadel Group has an ROCE of 1.5%. In absolute terms, that's a low return and it also under-performs the IT industry average of 9.9%.
In the above chart we have measured Citadel Group'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 Citadel Group.
What Can We Tell From Citadel Group's ROCE Trend?
We weren't thrilled with the trend because Citadel Group's ROCE has reduced by 81% over the last five years, while the business employed 247% more capital. Usually this isn't ideal, but given Citadel Group conducted a capital raising before their most recent earnings announcement, that would've likely contributed, at least partially, to the increased capital employed figure. It's unlikely that all of the funds raised have been put to work yet, so as a consequence Citadel Group might not have received a full period of earnings contribution from it.
On a side note, Citadel Group has done well to pay down its current liabilities to 13% of total assets. That could partly explain why the ROCE has dropped. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.
The Bottom Line
In summary, despite lower returns in the short term, we're encouraged to see that Citadel Group is reinvesting for growth and has higher sales as a result. In light of this, the stock has only gained 34% over the last five years. Therefore we'd recommend looking further into this stock to confirm if it has the makings of a good investment.
One more thing: We've identified 3 warning signs with Citadel Group (at least 2 which are significant) , and understanding them would certainly be useful.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
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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