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If we're looking to avoid a business that is in decline, what are the trends that can warn us ahead of time? Businesses in decline often have two underlying trends, firstly, a declining return on capital employed (ROCE) and a declining base of capital employed. This reveals that the company isn't compounding shareholder wealth because returns are falling and its net asset base is shrinking. And from a first read, things don't look too good at Espey Mfg. & Electronics (NYSEMKT:ESP), so let's see why.
Understanding Return On Capital Employed (ROCE)
For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. To calculate this metric for Espey Mfg. & Electronics, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.037 = US$1.2m ÷ (US$38m - US$6.7m) (Based on the trailing twelve months to June 2020).
So, Espey Mfg. & Electronics has an ROCE of 3.7%. In absolute terms, that's a low return and it also under-performs the Electrical industry average of 9.4%.
Historical performance is a great place to start when researching a stock so above you can see the gauge for Espey Mfg. & Electronics' ROCE against it's prior returns. If you want to delve into the historical earnings, revenue and cash flow of Espey Mfg. & Electronics, check out these free graphs here.
How Are Returns Trending?
We are a bit worried about the trend of returns on capital at Espey Mfg. & Electronics. To be more specific, the ROCE was 14% five years ago, but since then it has dropped noticeably. 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. So because these trends aren't typically conducive to creating a multi-bagger, we wouldn't hold our breath on Espey Mfg. & Electronics becoming one if things continue as they have.
All in all, the lower returns from the same amount of capital employed aren't exactly signs of a compounding machine. And long term shareholders have watched their investments stay flat over the last five years. With underlying trends that aren't great in these areas, we'd consider looking elsewhere.
One more thing: We've identified 4 warning signs with Espey Mfg. & Electronics (at least 1 which doesn't sit too well with us) , and understanding these would certainly be useful.
While Espey Mfg. & Electronics isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.
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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