Here's What's Concerning About Smart Metering Systems' (LON:SMS) Returns On Capital

If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. 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. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. However, after briefly looking over the numbers, we don't think Smart Metering Systems (LON:SMS) has the makings of a multi-bagger going forward, but let's have a look at why that may be.

What Is 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. Analysts use this formula to calculate it for Smart Metering Systems:

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

0.041 = UK£23m ÷ (UK£619m - UK£61m) (Based on the trailing twelve months to June 2022).

Thus, Smart Metering Systems has an ROCE of 4.1%. Ultimately, that's a low return and it under-performs the Commercial Services industry average of 8.3%.

Our analysis indicates that SMS is potentially overvalued!

In the above chart we have measured Smart Metering Systems' 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 Smart Metering Systems here for free.

The Trend Of ROCE

When we looked at the ROCE trend at Smart Metering Systems, we didn't gain much confidence. Around five years ago the returns on capital were 11%, but since then they've fallen to 4.1%. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.

On a side note, Smart Metering Systems has done well to pay down its current liabilities to 9.8% of total assets. That could partly explain why the ROCE has dropped. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. 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.

The Bottom Line

Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Smart Metering Systems. These trends are starting to be recognized by investors since the stock has delivered a 24% gain to shareholders who've held over the last five years. Therefore we'd recommend looking further into this stock to confirm if it has the makings of a good investment.

Like most companies, Smart Metering Systems does come with some risks, and we've found 2 warning signs that you should be aware of.

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.