Here's What's Concerning About Downer EDI's (ASX:DOW) Returns On Capital

When we're researching a company, it's sometimes hard to find the warning signs, but there are some financial metrics that can help spot trouble early. More often than not, we'll see a declining return on capital employed (ROCE) and a declining amount of capital employed. Ultimately this means that the company is earning less per dollar invested and on top of that, it's shrinking its base of capital employed. In light of that, from a first glance at Downer EDI (ASX:DOW), we've spotted some signs that it could be struggling, so let's investigate.

Return On Capital Employed (ROCE): What Is It?

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 Downer EDI:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.038 = AU$178m ÷ (AU$7.5b - AU$2.7b) (Based on the trailing twelve months to June 2022).

Therefore, Downer EDI has an ROCE of 3.8%. Ultimately, that's a low return and it under-performs the Commercial Services industry average of 10%.

Our analysis indicates that DOW is potentially undervalued!

In the above chart we have measured Downer EDI's prior ROCE against its prior performance, but the future is arguably more important. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Downer EDI.

What The Trend Of ROCE Can Tell Us

We are a bit worried about the trend of returns on capital at Downer EDI. To be more specific, the ROCE was 5.6% 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 Downer EDI to turn into a multi-bagger.

The Bottom Line On Downer EDI's ROCE

In summary, it's unfortunate that Downer EDI is generating lower returns from the same amount of capital. Long term shareholders who've owned the stock over the last five years have experienced a 22% depreciation in their investment, so it appears the market might not like these trends either. Unless there is a shift to a more positive trajectory in these metrics, we would look elsewhere.

On a final note, we've found 2 warning signs for Downer EDI that we think you should be aware of.

While Downer EDI isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

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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.