To find a multi-bagger stock, what are the underlying trends we should look for in a business? 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. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. Although, when we looked at Energy Recovery (NASDAQ:ERII), it didn't seem to tick all of these boxes.

Return On Capital Employed (ROCE): What Is It?

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 Energy Recovery is:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.063 = US$13m ÷ (US$223m - US$16m) (Based on the trailing twelve months to September 2023).

Therefore, Energy Recovery has an ROCE of 6.3%. In absolute terms, that's a low return and it also under-performs the Machinery industry average of 12%.

Check out our latest analysis for Energy Recovery

Above you can see how the current ROCE for Energy Recovery compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Energy Recovery.

So How Is Energy Recovery's ROCE Trending?

On the surface, the trend of ROCE at Energy Recovery doesn't inspire confidence. Over the last five years, returns on capital have decreased to 6.3% from 9.0% five years ago. However it looks like Energy Recovery 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's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.

The Key Takeaway

Bringing it all together, while we're somewhat encouraged by Energy Recovery's reinvestment in its own business, we're aware that returns are shrinking. Investors must think there's better things to come because the stock has knocked it out of the park, delivering a 136% gain to shareholders who have held over the last five years. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.

Energy Recovery does have some risks though, and we've spotted 1 warning sign for Energy Recovery that you might be interested in.

While Energy Recovery 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.

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.