Be Wary Of Smith & Nephew (LON:SN.) And Its Returns On Capital

What trends should we look for it we want to identify stocks that can multiply in value over the long term? In a perfect world, we'd like to see a company investing more capital into its business and ideally the returns earned from that capital are also increasing. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. Having said that, from a first glance at Smith & Nephew (LON:SN.) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.

Understanding Return On Capital Employed (ROCE)

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. The formula for this calculation on Smith & Nephew is:

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

0.046 = US$433m ÷ (US$11b - US$1.7b) (Based on the trailing twelve months to December 2020).

So, Smith & Nephew has an ROCE of 4.6%. In absolute terms, that's a low return and it also under-performs the Medical Equipment industry average of 6.9%.

Check out our latest analysis for Smith & Nephew

Above you can see how the current ROCE for Smith & Nephew compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Smith & Nephew.

How Are Returns Trending?

In terms of Smith & Nephew's historical ROCE movements, the trend isn't fantastic. Around five years ago the returns on capital were 13%, but since then they've fallen to 4.6%. Given the business is employing more capital while revenue has slipped, this is a bit concerning. If this were to continue, you might be looking at a company that is trying to reinvest for growth but is actually losing market share since sales haven't increased.

The Key Takeaway

We're a bit apprehensive about Smith & Nephew because despite more capital being deployed in the business, returns on that capital and sales have both fallen. However the stock has delivered a 45% return to shareholders over the last five years, so investors might be expecting the trends to turn around. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.

One more thing to note, we've identified 3 warning signs with Smith & Nephew and understanding these should be part of your investment process.

If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive returns on equity.

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This article by Simply Wall St is general in nature. 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.
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