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When it comes to investing, there are some useful financial metrics that can warn us when a business is potentially in trouble. More often than not, we'll see a declining return on capital employed (ROCE) and a declining amount of capital employed. This indicates the company is producing less profit from its investments and its total assets are decreasing. In light of that, from a first glance at Psychemedics (NASDAQ:PMD), we've spotted some signs that it could be struggling, so let's investigate.
Understanding 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 Psychemedics:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.0036 = US$65k ÷ (US$24m - US$5.3m) (Based on the trailing twelve months to September 2021).
Thus, Psychemedics has an ROCE of 0.4%. In absolute terms, that's a low return and it also under-performs the Healthcare industry average of 12%.
Historical performance is a great place to start when researching a stock so above you can see the gauge for Psychemedics' ROCE against it's prior returns. If you're interested in investigating Psychemedics' past further, check out this free graph of past earnings, revenue and cash flow.
What Can We Tell From Psychemedics' ROCE Trend?
We are a bit worried about the trend of returns on capital at Psychemedics. About five years ago, returns on capital were 32%, however they're now substantially lower than that as we saw above. On top of that, it's worth noting that the amount of capital employed within the business has remained relatively steady. 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 Psychemedics to turn into a multi-bagger.
The Bottom Line
All in all, the lower returns from the same amount of capital employed aren't exactly signs of a compounding machine. It should come as no surprise then that the stock has fallen 58% over the last five years, so it looks like investors are recognizing these changes. Unless there is a shift to a more positive trajectory in these metrics, we would look elsewhere.
One final note, you should learn about the 4 warning signs we've spotted with Psychemedics (including 1 which shouldn't be ignored) .
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. 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.
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