What are the early trends we should look for to identify a stock that could multiply in value over the long term? One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing 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. In light of that, when we looked at Ross Stores (NASDAQ:ROST) and its ROCE trend, we weren’t exactly thrilled.
What is Return On Capital Employed (ROCE)?
For those that aren’t sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. The formula for this calculation on Ross Stores is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
0.049 = US$430m ÷ (US$13b – US$4.0b) (Based on the trailing twelve months to January 2021).
Therefore, Ross Stores has an ROCE of 4.9%. In absolute terms, that’s a low return and it also under-performs the Specialty Retail industry average of 14%.
NasdaqGS:ROST Return on Capital Employed May 5th 2021
Above you can see how the current ROCE for Ross Stores 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 Ross Stores here for free.
So How Is Ross Stores’ ROCE Trending?
On the surface, the trend of ROCE at Ross Stores doesn’t inspire confidence. Over the last five years, returns on capital have decreased to 4.9% from 50% five years ago. Given the business is employing more capital while revenue has slipped, this is a bit concerning. This could mean that the business is losing its competitive advantage or market share, because while more money is being put into ventures, it’s actually producing a lower return – “less bang for their buck” per se.
In summary, we’re somewhat concerned by Ross Stores’ diminishing returns on increasing amounts of capital. The market must be rosy on the stock’s future because even though the underlying trends aren’t too encouraging, the stock has soared 139%. In any case, the current underlying trends don’t bode well for long term performance so unless they reverse, we’d start looking elsewhere.
One more thing to note, we’ve identified 4 warning signs with Ross Stores and understanding them should be part of your investment process.
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.
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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