Returns On Capital Signal Tricky Times Ahead For Cochlear (ASX:COH)

If you're not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out for. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. In light of that, when we looked at Cochlear (ASX:COH) and its ROCE trend, we weren't exactly thrilled.

Understanding 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. Analysts use this formula to calculate it for Cochlear:

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

0.11 = AU$225m ÷ (AU$2.4b - AU$370m) (Based on the trailing twelve months to December 2020).

Thus, Cochlear has an ROCE of 11%. In absolute terms, that's a satisfactory return, but compared to the Medical Equipment industry average of 8.8% it's much better.

See our latest analysis for Cochlear

Above you can see how the current ROCE for Cochlear 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 Cochlear here for free.

How Are Returns Trending?

The trend of ROCE doesn't look fantastic because it's fallen from 44% five years ago, while the business's capital employed increased by 277%. That being said, Cochlear 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 Cochlear's earnings and if they change as a result from the capital raise.

On a side note, Cochlear has done well to pay down its current liabilities to 16% of total assets. So we could link some of this to the decrease in ROCE. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.

In Conclusion...

From the above analysis, we find it rather worrisome that returns on capital and sales for Cochlear have fallen, meanwhile the business is employing more capital than it was five years ago. However the stock has delivered a 94% return to shareholders over the last five years, so investors might be expecting the trends to turn around. In any case, the current underlying trends don't bode well for long term performance so unless they reverse, we'd start looking elsewhere.

Cochlear could be trading at an attractive price in other respects, so you might find our free intrinsic value estimation on our platform quite valuable.

While Cochlear may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.

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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.
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