The Returns On Capital At Eaton (NYSE:ETN) Don't Inspire Confidence
If we're looking to avoid a business that is in decline, what are the trends that can warn us ahead of time? Typically, we'll see the trend of both return on capital employed (ROCE) declining and this usually coincides with a decreasing amount of capital employed. Trends like this ultimately mean the business is reducing its investments and also earning less on what it has invested. So after glancing at the trends within Eaton (NYSE:ETN), we weren't too hopeful.
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. Analysts use this formula to calculate it for Eaton:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.069 = US$1.8b ÷ (US$32b - US$5.9b) (Based on the trailing twelve months to December 2020).
Thus, Eaton has an ROCE of 6.9%. In absolute terms, that's a low return and it also under-performs the Electrical industry average of 9.2%.
View our latest analysis for Eaton
In the above chart we have measured Eaton's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Eaton here for free.
How Are Returns Trending?
In terms of Eaton's historical ROCE movements, the trend doesn't inspire confidence. Unfortunately the returns on capital have diminished from the 9.0% that they were earning five years ago. Meanwhile, capital employed in the business has stayed roughly the flat over the period. Since returns are falling and the business has the same amount of assets employed, this can suggest it's a mature business that hasn't had much growth in the last five years. If these trends continue, we wouldn't expect Eaton to turn into a multi-bagger.
What We Can Learn From Eaton's ROCE
All in all, the lower returns from the same amount of capital employed aren't exactly signs of a compounding machine. The market must be rosy on the stock's future because even though the underlying trends aren't too encouraging, the stock has soared 157%. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.
Eaton does have some risks though, and we've spotted 2 warning signs for Eaton that you might be interested in.
If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive 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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