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If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? 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. If you see this, it typically means it’s a company with a great business model and plenty of profitable reinvestment opportunities. Having said that, from a first glance at Sterling Tools (NSE:STERTOOLS) we aren’t jumping out of our chairs at how returns are trending, but let’s have a deeper look.
Understanding 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 Sterling Tools is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
0.11 = ₹512m ÷ (₹5.9b – ₹1.5b) (Based on the trailing twelve months to September 2022).
Therefore, Sterling Tools has an ROCE of 11%. That’s a relatively normal return on capital, and it’s around the 13% generated by the Auto Components industry.
Check out our latest analysis for Sterling Tools
Historical performance is a great place to start when researching a stock so above you can see the gauge for Sterling Tools’ ROCE against it’s prior returns. If you’d like to look at how Sterling Tools has performed in the past in other metrics, you can view this free graph of past earnings, revenue and cash flow.
What The Trend Of ROCE Can Tell Us
In terms of Sterling Tools’ historical ROCE movements, the trend isn’t fantastic. Around five years ago the returns on capital were 26%, but since then they’ve fallen to 11%. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.
What We Can Learn From Sterling Tools’ ROCE
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Sterling Tools. However, despite the promising trends, the stock has fallen 24% over the last five years, so there might be an opportunity here for astute investors. As a result, we’d recommend researching this stock further to uncover what other fundamentals of the business can show us.
Since virtually every company faces some risks, it’s worth knowing what they are, and we’ve spotted 2 warning signs for Sterling Tools (of which 1 is potentially serious!) that you should know about.
While Sterling Tools 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.
Valuation is complex, but we’re helping make it simple.
Find out whether Sterling Tools is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.
View the Free Analysis
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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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