What trends should we look for it we want to identify stocks that can multiply in value over the long term? Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing 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. Speaking of which, we noticed some great changes in Diamond Offshore Drilling's (NYSE:DO) returns on capital, so let's have a look.

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. Analysts use this formula to calculate it for Diamond Offshore Drilling:

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

0.033 = US$47m ÷ (US$1.7b - US$296m) (Based on the trailing twelve months to December 2023).

Thus, Diamond Offshore Drilling has an ROCE of 3.3%. Ultimately, that's a low return and it under-performs the Energy Services industry average of 12%.

Above you can see how the current ROCE for Diamond Offshore Drilling 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 Diamond Offshore Drilling for free.

What The Trend Of ROCE Can Tell Us

It's great to see that Diamond Offshore Drilling has started to generate some pre-tax earnings from prior investments. While the business is profitable now, it used to be incurring losses on invested capital five years ago. At first glance, it seems the business is getting more proficient at generating returns, because over the same period, the amount of capital employed has reduced by 76%. Diamond Offshore Drilling could be selling under-performing assets since the ROCE is improving.

For the record though, there was a noticeable increase in the company's current liabilities over the period, so we would attribute some of the ROCE growth to that. Essentially the business now has suppliers or short-term creditors funding about 17% of its operations, which isn't ideal. It's worth keeping an eye on this because as the percentage of current liabilities to total assets increases, some aspects of risk also increase.

Our Take On Diamond Offshore Drilling's ROCE

In the end, Diamond Offshore Drilling has proven it's capital allocation skills are good with those higher returns from less amount of capital. Since the stock has returned a solid 13% to shareholders over the last year, it's fair to say investors are beginning to recognize these changes. In light of that, we think it's worth looking further into this stock because if Diamond Offshore Drilling can keep these trends up, it could have a bright future ahead.

If you'd like to know about the risks facing Diamond Offshore Drilling, we've discovered 1 warning sign that you should be aware of.

While Diamond Offshore Drilling 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.