Dialight (LON:DIA) May Have Issues Allocating Its Capital

If you're not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out for. Amongst other things, we'll want to see two things; firstly, a growing return on capital employed (ROCE) and secondly, an expansion in the company's amount of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. Although, when we looked at Dialight (LON:DIA), it didn't seem to tick all of these boxes.

Understanding 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. The formula for this calculation on Dialight is:

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

0.034 = UK£3.4m ÷ (UK£140m - UK£40m) (Based on the trailing twelve months to June 2022).

Thus, Dialight has an ROCE of 3.4%. Ultimately, that's a low return and it under-performs the Electrical industry average of 15%.

Our analysis indicates that DIA is potentially overvalued!

Above you can see how the current ROCE for Dialight compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

What The Trend Of ROCE Can Tell Us

In terms of Dialight's historical ROCE movements, the trend isn't fantastic. Around five years ago the returns on capital were 19%, but since then they've fallen to 3.4%. 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. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.

The Bottom Line On Dialight's ROCE

While returns have fallen for Dialight in recent times, we're encouraged to see that sales are growing and that the business is reinvesting in its operations. And there could be an opportunity here if other metrics look good too, because the stock has declined 57% in the last five years. As a result, we'd recommend researching this stock further to uncover what other fundamentals of the business can show us.

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

While Dialight 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.