Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. 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. Although, when we looked at Greenalia (BME:GRN), it didn't seem to tick all of these boxes.
Understanding 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. To calculate this metric for Greenalia, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.022 = €6.0m ÷ (€302m - €35m) (Based on the trailing twelve months to December 2020).
Thus, Greenalia has an ROCE of 2.2%. Ultimately, that's a low return and it under-performs the Renewable Energy industry average of 5.6%.
In the above chart we have measured Greenalia's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Greenalia here for free.
What Does the ROCE Trend For Greenalia Tell Us?
In terms of Greenalia's historical ROCE movements, the trend isn't fantastic. Around five years ago the returns on capital were 8.0%, but since then they've fallen to 2.2%. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. If these investments prove successful, this can bode very well for long term stock performance.
On a related note, Greenalia has decreased its current liabilities to 12% 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.
What We Can Learn From Greenalia's ROCE
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Greenalia. And long term investors must be optimistic going forward because the stock has returned a huge 205% to shareholders in the last three years. So while the underlying trends could already be accounted for by investors, we still think this stock is worth looking into further.
Greenalia does have some risks, we noticed 3 warning signs (and 2 which are concerning) we think you should know about.
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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