Smart Metering Systems (LON:SMS) May Have Issues Allocating Its Capital

If you're looking for a multi-bagger, there's a few things to keep an eye out for. Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. In light of that, when we looked at Smart Metering Systems (LON:SMS) and its ROCE trend, we weren't exactly thrilled.

Return On Capital Employed (ROCE): What is it?

For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. To calculate this metric for Smart Metering Systems, this is the formula:

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

0.039 = UK£22m ÷ (UK£633m - UK£58m) (Based on the trailing twelve months to December 2021).

Thus, Smart Metering Systems has an ROCE of 3.9%. Ultimately, that's a low return and it under-performs the Commercial Services industry average of 11%.

Check out our latest analysis for Smart Metering Systems

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 to see what analysts are forecasting going forward, you should check out our free report for Smart Metering Systems.

What Does the ROCE Trend For Smart Metering Systems Tell Us?

On the surface, the trend of ROCE at Smart Metering Systems doesn't inspire confidence. Over the last five years, returns on capital have decreased to 3.9% from 13% five years ago. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It may take some time before the company starts to see any change in earnings from these investments.

On a side note, Smart Metering Systems has done well to pay down its current liabilities to 9.2% of total assets. That could partly explain why the ROCE has dropped. 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.

In Conclusion...

To conclude, we've found that Smart Metering Systems is reinvesting in the business, but returns have been falling. Although the market must be expecting these trends to improve because the stock has gained 92% over the last five years. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.

If you want to know some of the risks facing Smart Metering Systems we've found 4 warning signs (1 is potentially serious!) that you should be aware of before investing here.

While Smart Metering Systems isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

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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.