Investors Could Be Concerned With Downer EDI's (ASX:DOW) Returns On Capital
To find a multi-bagger stock, what are the underlying trends we should look for in a business? Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. However, after investigating Downer EDI (ASX:DOW), we don't think it's current trends fit the mold of a multi-bagger.
What is Return On Capital Employed (ROCE)?
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 Downer EDI is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.038 = AU$204m ÷ (AU$8.3b - AU$3.0b) (Based on the trailing twelve months to December 2020).
Therefore, Downer EDI has an ROCE of 3.8%. In absolute terms, that's a low return and it also under-performs the Commercial Services industry average of 9.0%.
Check out our latest analysis for Downer EDI
Above you can see how the current ROCE for Downer EDI 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.
How Are Returns Trending?
We weren't thrilled with the trend because Downer EDI's ROCE has reduced by 62% over the last five years, while the business employed 89% more capital. That being said, Downer EDI raised some capital prior to their latest results being released, so that could partly explain the increase in capital employed. Downer EDI probably hasn't received a full year of earnings yet from the new funds it raised, so these figures should be taken with a grain of salt.
The Bottom Line
Bringing it all together, while we're somewhat encouraged by Downer EDI's reinvestment in its own business, we're aware that returns are shrinking. Although the market must be expecting these trends to improve because the stock has gained 62% over the last five years. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.
Downer EDI does have some risks, we noticed 3 warning signs (and 1 which can't be ignored) we think you should know about.
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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