Returns On Capital Signal Tricky Times Ahead For Gamma Communications (LON:GAMA)

Did you know there are some financial metrics that can provide clues of a potential multi-bagger? Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. However, after investigating Gamma Communications (LON:GAMA), we don't think it's current trends fit the mold of a multi-bagger.

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 Gamma Communications, this is the formula:

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

0.19 = UK£68m ÷ (UK£426m - UK£72m) (Based on the trailing twelve months to June 2023).

So, Gamma Communications has an ROCE of 19%. In absolute terms, that's a satisfactory return, but compared to the Telecom industry average of 9.1% it's much better.

View our latest analysis for Gamma Communications

In the above chart we have measured Gamma Communications' prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

So How Is Gamma Communications' ROCE Trending?

When we looked at the ROCE trend at Gamma Communications, we didn't gain much confidence. Around five years ago the returns on capital were 24%, but since then they've fallen to 19%. Meanwhile, the business is utilizing more capital but this hasn't moved the needle much in terms of sales in the past 12 months, so this could reflect longer term investments. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.

On a related note, Gamma Communications has decreased its current liabilities to 17% 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. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.

What We Can Learn From Gamma Communications' ROCE

Bringing it all together, while we're somewhat encouraged by Gamma Communications' reinvestment in its own business, we're aware that returns are shrinking. And with the stock having returned a mere 36% in the last five years to shareholders, you could argue that they're aware of these lackluster trends. So if you're looking for a multi-bagger, the underlying trends indicate you may have better chances elsewhere.

While Gamma Communications doesn't shine too bright in this respect, it's still worth seeing if the company is trading at attractive prices. You can find that out with our FREE intrinsic value estimation on our platform.

While Gamma Communications 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.