Capital Allocation Trends At Solid State (LON:SOLI) Aren't Ideal

What trends should we look for it we want to identify stocks that can multiply in value over the long term? 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. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. Having said that, from a first glance at Solid State (LON:SOLI) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.

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. To calculate this metric for Solid State, this is the formula:

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

0.12 = UK£4.5m ÷ (UK£54m - UK£16m) (Based on the trailing twelve months to March 2021).

So, Solid State has an ROCE of 12%. That's a pretty standard return and it's in line with the industry average of 12%.

See our latest analysis for Solid State

Above you can see how the current ROCE for Solid State 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 Solid State.

So How Is Solid State's ROCE Trending?

On the surface, the trend of ROCE at Solid State doesn't inspire confidence. Around five years ago the returns on capital were 17%, but since then they've fallen to 12%. 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 related note, Solid State has decreased its current liabilities to 29% of total assets. So we could link some of this to the decrease in ROCE. 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 On Solid State's ROCE

To conclude, we've found that Solid State is reinvesting in the business, but returns have been falling. Investors must think there's better things to come because the stock has knocked it out of the park, delivering a 244% gain to shareholders who have held 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're still interested in Solid State it's worth checking out our FREE intrinsic value approximation to see if it's trading at an attractive price in other respects.

While Solid State 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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