Capital Allocation Trends At Pharmanutra (BIT:PHN) 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. So while Pharmanutra (BIT:PHN) has a high ROCE right now, lets see what we can decipher from how returns are changing.

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. The formula for this calculation on Pharmanutra is:

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

0.37 = €16m ÷ (€56m - €14m) (Based on the trailing twelve months to June 2021).

Thus, Pharmanutra has an ROCE of 37%. In absolute terms that's a great return and it's even better than the Personal Products industry average of 8.1%.

View our latest analysis for Pharmanutra

Above you can see how the current ROCE for Pharmanutra compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

What Does the ROCE Trend For Pharmanutra Tell Us?

On the surface, the trend of ROCE at Pharmanutra doesn't inspire confidence. While it's comforting that the ROCE is high, five years ago it was 60%. 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, Pharmanutra has decreased its current liabilities to 25% 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.

The Bottom Line

Bringing it all together, while we're somewhat encouraged by Pharmanutra's reinvestment in its own business, we're aware that returns are shrinking. Investors must think there's better things to come because the stock has knocked it out of the park, delivering a 386% gain to shareholders who have held over the last three years. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.

On a separate note, we've found 1 warning sign for Pharmanutra you'll probably want to know about.

Pharmanutra is not the only stock earning high returns. If you'd like to see more, check out our free list of companies earning high returns on equity with solid fundamentals.

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.

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