There Are Reasons To Feel Uneasy About Cochlear's (ASX:COH) Returns On Capital

If you're looking for a multi-bagger, there's a few things to keep an eye out for. In a perfect world, we'd like to see a company investing more capital into its business and ideally the returns earned from that capital are also increasing. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. However, after investigating Cochlear (ASX:COH), we don't think it's current trends fit the mold of a multi-bagger.

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 Cochlear, this is the formula:

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).

Therefore, Cochlear has an ROCE of 11%. On its own, that's a standard return, however it's much better than the 8.8% generated by the Medical Equipment industry.

View our latest analysis for Cochlear

In the above chart we have measured Cochlear's prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

So How Is Cochlear's ROCE Trending?

We weren't thrilled with the trend because Cochlear's ROCE has reduced by 74% over the last five years, while the business employed 277% more capital. Usually this isn't ideal, but given Cochlear conducted a capital raising before their most recent earnings announcement, that would've likely contributed, at least partially, to the increased capital employed figure. Cochlear probably hasn't received a full year of earnings yet from the new funds it raised, so these figures should be taken with a grain of salt.

On a side note, Cochlear has done well to pay down its current liabilities to 16% of total assets. That could partly explain why the ROCE has dropped. 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.

The Key Takeaway

In summary, we're somewhat concerned by Cochlear's diminishing returns on increasing amounts of capital. Since the stock has skyrocketed 117% over the last five years, it looks like investors have high expectations of the stock. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.

One more thing to note, we've identified 1 warning sign with Cochlear and understanding this should be part of your investment process.

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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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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