Should You Be Impressed By Donaldson Company's (NYSE:DCI) Returns on Capital?
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. Amongst other things, we'll want to see two things; firstly, a growing return on capital employed (ROCE) and secondly, an expansion in the company's 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. Although, when we looked at Donaldson Company (NYSE:DCI), it didn't seem to tick all of these boxes.
Return On Capital Employed (ROCE): What is it?
Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. The formula for this calculation on Donaldson Company is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.19 = US$360m ÷ (US$2.3b - US$433m) (Based on the trailing twelve months to April 2020).
Thus, Donaldson Company has an ROCE of 19%. In absolute terms, that's a satisfactory return, but compared to the Machinery industry average of 9.1% it's much better.
View our latest analysis for Donaldson Company
Above you can see how the current ROCE for Donaldson Company compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.
What The Trend Of ROCE Can Tell Us
In terms of Donaldson Company's historical ROCE movements, the trend isn't fantastic. Around five years ago the returns on capital were 26%, but since then they've fallen to 19%. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. 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.
On a related note, Donaldson Company has decreased its current liabilities to 19% of total assets. So we could link some of this to the decrease in ROCE. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. 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 Bottom Line
Bringing it all together, while we're somewhat encouraged by Donaldson Company's reinvestment in its own business, we're aware that returns are shrinking. Since the stock has gained an impressive 85% over the last five years, investors must think there's better things to come. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.
If you want to continue researching Donaldson Company, you might be interested to know about the 2 warning signs that our analysis has discovered.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
This article by Simply Wall St is general in nature. 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.
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