There Are Reasons To Feel Uneasy About Downer EDI's (ASX:DOW) Returns On Capital

If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base of capital employed. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. Having said that, from a first glance at Downer EDI (ASX:DOW) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.

What is 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 Downer EDI, this is the formula:

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

0.038 = AU$204m ÷ (AU$8.3b - AU$3.0b) (Based on the trailing twelve months to December 2020).

Therefore, Downer EDI has an ROCE of 3.8%. In absolute terms, that's a low return and it also under-performs the Commercial Services industry average of 9.0%.

Check out our latest analysis for Downer EDI

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.

The Trend Of ROCE

Unfortunately, the trend isn't great with ROCE falling from 10% five years ago, while capital employed has grown 89%. That being said, Downer EDI raised some capital prior to their latest results being released, so that could partly explain the increase in capital employed. The funds raised likely haven't been put to work yet so it's worth watching what happens in the future with Downer EDI's earnings and if they change as a result from the capital raise.

The Key Takeaway

Bringing it all together, while we're somewhat encouraged by Downer EDI's reinvestment in its own business, we're aware that returns are shrinking. Although the market must be expecting these trends to improve because the stock has gained 74% over the last five years. But if the trajectory of these underlying trends continue, we think the likelihood of it being a multi-bagger from here isn't high.

Downer EDI does have some risks, we noticed 3 warning signs (and 1 which is a bit concerning) we think you should know about.

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. 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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