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

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. Although, when we looked at Downer EDI (ASX:DOW), it didn't seem to tick all of these boxes.

What is Return On Capital Employed (ROCE)?

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its 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)

0.061 = AU$292m ÷ (AU$8.1b - AU$3.3b) (Based on the trailing twelve months to June 2021).

Thus, Downer EDI has an ROCE of 6.1%. In absolute terms, that's a low return and it also under-performs the Commercial Services industry average of 11%.

See 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, you can check out the forecasts from the analysts covering Downer EDI here for free.

So How Is Downer EDI's ROCE Trending?

In terms of Downer EDI's historical ROCE movements, the trend isn't fantastic. Over the last five years, returns on capital have decreased to 6.1% from 10% five years ago. However it looks like Downer EDI might be reinvesting for long term growth because while capital employed has increased, the company's sales haven't changed much in the last 12 months. It may take some time before the company starts to see any change in earnings from these investments.

On a separate but related note, it's important to know that Downer EDI has a current liabilities to total assets ratio of 41%, which we'd consider pretty high. This can bring about some risks because the company is basically operating with a rather large reliance on its suppliers or other sorts of short-term creditors. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.

The Bottom Line On Downer EDI's ROCE

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. Unsurprisingly, the stock has only gained 6.1% over the last five years, which potentially indicates that investors are accounting for this going forward. So if you're looking for a multi-bagger, the underlying trends indicate you may have better chances elsewhere.

On a separate note, we've found 1 warning sign for Downer EDI you'll probably want to 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. 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.