Capital Allocation Trends At Grendene (BVMF:GRND3) Aren't Ideal

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. In light of that, when we looked at Grendene (BVMF:GRND3) and its ROCE trend, we weren't exactly thrilled.

Understanding 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 Grendene:

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

0.10 = R$413m ÷ (R$4.8b - R$739m) (Based on the trailing twelve months to March 2021).

Thus, Grendene has an ROCE of 10%. In absolute terms, that's a satisfactory return, but compared to the Luxury industry average of 8.5% it's much better.

View our latest analysis for Grendene

Historical performance is a great place to start when researching a stock so above you can see the gauge for Grendene's ROCE against it's prior returns. If you'd like to look at how Grendene has performed in the past in other metrics, you can view this free graph of past earnings, revenue and cash flow.

What Can We Tell From Grendene's ROCE Trend?

When we looked at the ROCE trend at Grendene, we didn't gain much confidence. To be more specific, ROCE has fallen from 16% over the last five years. Meanwhile, the business is utilizing more capital but this hasn't moved the needle much in terms of sales in the past 12 months, so this could reflect longer term investments. It may take some time before the company starts to see any change in earnings from these investments.

What We Can Learn From Grendene's ROCE

In summary, Grendene is reinvesting funds back into the business for growth but unfortunately it looks like sales haven't increased much just yet. Yet to long term shareholders the stock has gifted them an incredible 136% 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.

One more thing: We've identified 3 warning signs with Grendene (at least 1 which makes us a bit uncomfortable) , and understanding these would certainly be useful.

While Grendene 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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