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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. 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 we looked into Teradata (NYSE:TDC), the trends above didn't look too great.
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. Analysts use this formula to calculate it for Teradata:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.12 = US$150m ÷ (US$2.2b - US$955m) (Based on the trailing twelve months to March 2021).
Thus, Teradata has an ROCE of 12%. In absolute terms, that's a pretty normal return, and it's somewhat close to the Software industry average of 11%.
In the above chart we have measured Teradata'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 Teradata here for free.
The Trend Of ROCE
We are a bit worried about the trend of returns on capital at Teradata. Unfortunately the returns on capital have diminished from the 20% that they were earning five years ago. On top of that, it's worth noting that the amount of capital employed within the business has remained relatively steady. This combination can be indicative of a mature business that still has areas to deploy capital, but the returns received aren't as high due potentially to new competition or smaller margins. If these trends continue, we wouldn't expect Teradata to turn into a multi-bagger.
On a separate but related note, it's important to know that Teradata has a current liabilities to total assets ratio of 43%, which we'd consider pretty high. This effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. Ideally we'd like to see this reduce as that would mean fewer obligations bearing risks.
What We Can Learn From Teradata's ROCE
All in all, the lower returns from the same amount of capital employed aren't exactly signs of a compounding machine. But investors must be expecting an improvement of sorts because over the last five yearsthe stock has delivered a respectable 60% return. In any case, the current underlying trends don't bode well for long term performance so unless they reverse, we'd start looking elsewhere.
One more thing, we've spotted 4 warning signs facing Teradata that you might find interesting.
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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