There are a few key trends to look for if we want to identify the next multi-bagger. 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. However, after briefly looking over the numbers, we don't think RH (NYSE:RH) 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. To calculate this metric for RH, this is the formula:

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

0.13 = US$414m ÷ (US$4.2b - US$935m) (Based on the trailing twelve months to October 2023).

So, RH has an ROCE of 13%. That's a relatively normal return on capital, and it's around the 14% generated by the Specialty Retail industry.

In the above chart we have measured RH's prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free analyst report for RH .

The Trend Of ROCE

When we looked at the ROCE trend at RH, we didn't gain much confidence. Around five years ago the returns on capital were 26%, but since then they've fallen to 13%. Given the business is employing more capital while revenue has slipped, this is a bit concerning. 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, RH has done well to pay down its current liabilities to 22% 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. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.

The Key Takeaway

In summary, we're somewhat concerned by RH's diminishing returns on increasing amounts of capital. Since the stock has skyrocketed 104% over the last five years, it looks like investors have high expectations of the stock. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.

One more thing: We've identified 4 warning signs with RH (at least 2 which are a bit unpleasant) , and understanding them would certainly be useful.

While RH isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

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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.