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If you're looking at a mature business that's past the growth phase, what are some of the underlying trends that pop up? Businesses in decline often have two underlying trends, firstly, a declining return on capital employed (ROCE) and a declining base of capital employed. This combination can tell you that not only is the company investing less, it's earning less on what it does invest. In light of that, from a first glance at Domtar (NYSE:UFS), we've spotted some signs that it could be struggling, so let's investigate.
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 Domtar is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.015 = US$63m ÷ (US$4.8b - US$703m) (Based on the trailing twelve months to September 2020).
So, Domtar has an ROCE of 1.5%. In absolute terms, that's a low return and it also under-performs the Forestry industry average of 9.7%.
In the above chart we have measured Domtar'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 Domtar here for free.
What The Trend Of ROCE Can Tell Us
There is reason to be cautious about Domtar, given the returns are trending downwards. To be more specific, the ROCE was 6.7% five years ago, but since then it has dropped noticeably. Meanwhile, capital employed in the business has stayed roughly the flat over the period. 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 Domtar to turn into a multi-bagger.
Our Take On Domtar's ROCE
In the end, the trend of lower returns on the same amount of capital isn't typically an indication that we're looking at a growth stock. And long term shareholders have watched their investments stay flat over the last five years. That being the case, unless the underlying trends revert to a more positive trajectory, we'd consider looking elsewhere.
If you'd like to know about the risks facing Domtar, we've discovered 1 warning sign that you should be aware of.
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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