Dollarama (TSE:DOL) May Have Issues Allocating Its Capital

Did you know there are some financial metrics that can provide clues of a potential multi-bagger? One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing 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. So when we looked at Dollarama (TSE:DOL), they do have a high ROCE, but we weren't exactly elated from how returns are trending.

Return On Capital Employed (ROCE): What Is It?

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. The formula for this calculation on Dollarama is:

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

0.34 = CA$1.1b ÷ (CA$4.4b - CA$1.2b) (Based on the trailing twelve months to July 2022).

Therefore, Dollarama has an ROCE of 34%. In absolute terms that's a great return and it's even better than the Multiline Retail industry average of 13%.

Check out our latest analysis for Dollarama

In the above chart we have measured Dollarama's prior ROCE against its prior performance, but the future is arguably more important. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Dollarama.

The Trend Of ROCE

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 95%. Usually this isn't ideal, but given Dollarama conducted a capital raising before their most recent earnings announcement, that would've likely contributed, at least partially, to the increased capital employed figure. The funds raised likely haven't been put to work yet so it's worth watching what happens in the future with Dollarama's earnings and if they change as a result from the capital raise.

While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 28%, which has impacted the ROCE. Without this increase, it's likely that ROCE would be even lower than 34%. While the ratio isn't currently too high, it's worth keeping an eye on this because if it gets particularly high, the business could then face some new elements of risk.

The Bottom Line On Dollarama's ROCE

In summary, despite lower returns in the short term, we're encouraged to see that Dollarama is reinvesting for growth and has higher sales as a result. Furthermore the stock has climbed 80% over the last five years, it would appear that investors are upbeat about the future. So while investors seem to be recognizing these promising trends, we would look further into this stock to make sure the other metrics justify the positive view.

Since virtually every company faces some risks, it's worth knowing what they are, and we've spotted 2 warning signs for Dollarama (of which 1 shouldn't be ignored!) that you should know about.

If you'd like to see other companies earning high returns, check out our free list of companies earning high returns with solid balance sheets 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.