The returns on capital of the REA group (ASX: REA) do not inspire confidence

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If you are looking for a multi-bagger, there are a few things to look out for. Ideally, a business will display two trends; first growth return on capital employed (ROCE) and on the other hand, an increase amount capital employed. Basically, it means that a business has profitable initiatives that it can keep reinvesting in, which is a hallmark of a dialing machine. That said, while the ROCE is currently high for REA Group (ASX: REA), we don’t jump out of our chairs because the yields decrease.

Return on capital employed (ROCE): what is it?

For those who don’t know, ROCE is a measure of a company’s annual pre-tax profit (its return), relative to the capital employed in the company. The formula for this calculation on REA Group is:

Return on capital employed = Profit before interest and taxes (EBIT) ÷ (Total assets – Current liabilities)

0.31 = A $ 414 million ÷ (A $ 1.7 billion – A $ 415 million) (Based on the last twelve months up to December 2020).

So, The REA Group has a ROCE of 31%. It’s a fantastic return and not only that, it exceeds the 11% average earned by companies in a similar industry.

Check out our latest analysis for the REA group

ASX: REA Review of the capital employed on July 7, 2021

In the graph above, we measured the past ROCE of the REA Group against its past performance, but the future is arguably more important. If you’d like to see what analysts are forecasting for the future, you should check out our free report for the REA group.

What the ROCE trend can tell us

When we looked at the ROCE trend at REA Group, we didn’t gain much trust. To be more precise, while ROCE is still high, it has fallen from 45% where it was five years ago. However, it appears that REA Group is reinvesting for long-term growth, because while the capital employed has increased, the company’s sales haven’t changed much in the past 12 months. It may take some time for the business to begin to see a change in the benefits of these investments.

On the other hand, the current liabilities of the REA group have increased over the past five years to reach 24% of total assets, which effectively distorts ROCE to some extent. If current liabilities hadn’t grown as much as they did, the ROCE might actually be even lower. While the ratio is not too high right now, it’s worth keeping an eye on because if it gets particularly high then the business could face new elements of risk.

The result on the ROCE of the REA group

In summary, although we are somewhat encouraged by the reinvestment of the REA Group in its own business, we are aware that the returns are diminishing. Investors must think there are better things to come because the stock took it out of the park, offering a 183% gain to shareholders who have owned in the past five years. But if the trajectory of those underlying trends continues, we think the likelihood of it being multi-bagging from here is not high.

If you want to know the risks that REA Group faces, we have discovered 2 warning signs that you need to be aware of.

High yields are a key ingredient to strong performance, so check out our free list of stocks generating high returns on equity with strong balance sheets.

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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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