If you're not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out 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. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. However, after briefly looking over the numbers, we don't think Arrow Home Group (SZSE:001322) has the makings of a multi-bagger going forward, but let's have a look at why that may be.
Understanding 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 Arrow Home Group is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.11 = CN¥654m ÷ (CN¥10b - CN¥4.0b) (Based on the trailing twelve months to December 2022).
Thus, Arrow Home Group has an ROCE of 11%. On its own, that's a standard return, however it's much better than the 6.4% generated by the Building industry.
View our latest analysis for Arrow Home Group
Above you can see how the current ROCE for Arrow Home Group 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 Arrow Home Group here for free.
What Does the ROCE Trend For Arrow Home Group Tell Us?
On the surface, the trend of ROCE at Arrow Home Group doesn't inspire confidence. Around four years ago the returns on capital were 15%, but since then they've fallen to 11%. 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.
On a side note, Arrow Home Group has done well to pay down its current liabilities to 39% of total assets. So we could link some of this to the decrease in ROCE. 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.
In Conclusion...
From the above analysis, we find it rather worrisome that returns on capital and sales for Arrow Home Group have fallen, meanwhile the business is employing more capital than it was four years ago. Long term shareholders who've owned the stock over the last year have experienced a 29% depreciation in their investment, so it appears the market might not like these trends either. That being the case, unless the underlying trends revert to a more positive trajectory, we'd consider looking elsewhere.
One more thing: We've identified 2 warning signs with Arrow Home Group (at least 1 which is a bit concerning) , and understanding them would certainly be useful.
While Arrow Home Group 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.
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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.