The Returns At Metcash (ASX:MTS) Aren't Growing

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. In light of that, when we looked at Metcash (ASX:MTS) and its ROCE trend, we weren't exactly thrilled.

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. Analysts use this formula to calculate it for Metcash:

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

0.16 = AU$347m ÷ (AU$4.8b - AU$2.7b) (Based on the trailing twelve months to October 2020).

Thus, Metcash has an ROCE of 16%. In absolute terms, that's a pretty normal return, and it's somewhat close to the Consumer Retailing industry average of 14%.

See our latest analysis for Metcash

Above you can see how the current ROCE for Metcash compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Metcash here for free.

What Can We Tell From Metcash's ROCE Trend?

Things have been pretty stable at Metcash, with its capital employed and returns on that capital staying somewhat the same for the last five years. This tells us the company isn't reinvesting in itself, so it's plausible that it's past the growth phase. So don't be surprised if Metcash doesn't end up being a multi-bagger in a few years time. On top of that you'll notice that Metcash has been paying out a large portion (72%) of earnings in the form of dividends to shareholders. Most shareholders probably know this and own the stock for its dividend.

On a separate but related note, it's important to know that Metcash has a current liabilities to total assets ratio of 55%, 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.

Our Take On Metcash's ROCE

In summary, Metcash isn't compounding its earnings but is generating stable returns on the same amount of capital employed. Yet to long term shareholders the stock has gifted them an incredible 122% return in the last five years, so the market appears to be rosy about its future. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.

Metcash does have some risks, we noticed 2 warning signs (and 1 which shouldn't be ignored) we think you should know about.

For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.

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