If you're looking at a mature business that's past the growth phase, what are some of the underlying trends that pop up? Businesses in decline often have two underlying trends, firstly, a declining return on capital employed (ROCE) and a declining base of capital employed. This indicates the company is producing less profit from its investments and its total assets are decreasing. On that note, looking into Naito (TYO:7624), we weren't too upbeat about how things were going.
Understanding Return On Capital Employed (ROCE)
Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. The formula for this calculation on Naito is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.016 = JP¥192m ÷ (JP¥16b - JP¥4.4b) (Based on the trailing twelve months to February 2021).
So, Naito has an ROCE of 1.6%. Ultimately, that's a low return and it under-performs the Trade Distributors industry average of 6.4%.
Historical performance is a great place to start when researching a stock so above you can see the gauge for Naito's ROCE against it's prior returns. If you're interested in investigating Naito's past further, check out this free graph of past earnings, revenue and cash flow.
So How Is Naito's ROCE Trending?
There is reason to be cautious about Naito, given the returns are trending downwards. About five years ago, returns on capital were 5.8%, however they're now substantially lower than that as we saw above. Meanwhile, capital employed in the business has stayed roughly the flat over the period. Companies that exhibit these attributes tend to not be shrinking, but they can be mature and facing pressure on their margins from competition. So because these trends aren't typically conducive to creating a multi-bagger, we wouldn't hold our breath on Naito becoming one if things continue as they have.
The Key Takeaway
In the end, the trend of lower returns on the same amount of capital isn't typically an indication that we're looking at a growth stock. Despite the concerning underlying trends, the stock has actually gained 29% over the last five years, so it might be that the investors are expecting the trends to reverse. Either way, we aren't huge fans of the current trends and so with that we think you might find better investments elsewhere.
One more thing to note, we've identified 2 warning signs with Naito and understanding these should be part of your investment process.
While Naito 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.
When trading Naito or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted
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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.