Telefónica (BME:TEF) Could Be Struggling To Allocate Capital

To avoid investing in a business that's in decline, there's a few financial metrics that can provide early indications of aging. A business that's potentially in decline often shows two trends, a return on capital employed (ROCE) that's declining, and a base of capital employed that's also declining. Ultimately this means that the company is earning less per dollar invested and on top of that, it's shrinking its base of capital employed. And from a first read, things don't look too good at Telefónica (BME:TEF), so let's see why.

What Is Return On Capital Employed (ROCE)?

For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. Analysts use this formula to calculate it for Telefónica:

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

0.042 = €3.6b ÷ (€109b - €24b) (Based on the trailing twelve months to June 2023).

Thus, Telefónica has an ROCE of 4.2%. In absolute terms, that's a low return and it also under-performs the Telecom industry average of 9.4%.

See our latest analysis for Telefónica

In the above chart we have measured Telefónica'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 Telefónica.

What Can We Tell From Telefónica's ROCE Trend?

In terms of Telefónica's historical ROCE movements, the trend doesn't inspire confidence. Unfortunately the returns on capital have diminished from the 8.1% that they were earning five years ago. And on the capital employed front, the business is utilizing roughly the same amount of capital as it was back then. Companies that exhibit these attributes tend to not be shrinking, but they can be mature and facing pressure on their margins from competition. So because these trends aren't typically conducive to creating a multi-bagger, we wouldn't hold our breath on Telefónica becoming one if things continue as they have.

The Key Takeaway

All in all, the lower returns from the same amount of capital employed aren't exactly signs of a compounding machine. Long term shareholders who've owned the stock over the last five years have experienced a 33% depreciation in their investment, so it appears the market might not like these trends either. With underlying trends that aren't great in these areas, we'd consider looking elsewhere.

If you want to know some of the risks facing Telefónica we've found 3 warning signs (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

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. 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.