Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. In light of that, when we looked at Donaldson Company (NYSE:DCI) and its ROCE trend, we weren't exactly thrilled.
Return On Capital Employed (ROCE): What is it?
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 Donaldson Company is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.18 = US$340m ÷ (US$2.3b - US$419m) (Based on the trailing twelve months to October 2020).
Thus, Donaldson Company has an ROCE of 18%. On its own, that's a standard return, however it's much better than the 10% generated by the Machinery industry.
In the above chart we have measured Donaldson Company's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Donaldson Company here for free.
So How Is Donaldson Company's ROCE Trending?
In terms of Donaldson Company's historical ROCE movements, the trend isn't fantastic. To be more specific, ROCE has fallen from 24% over the last five years. However it looks like Donaldson Company might be reinvesting for long term growth because while capital employed has increased, the company's sales haven't changed much in the last 12 months. 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 side note, Donaldson Company has done well to pay down its current liabilities to 18% of total assets. So we could link some of this to the decrease in ROCE. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. 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 Key Takeaway
Bringing it all together, while we're somewhat encouraged by Donaldson Company'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 146% gain to shareholders who have held over the last five years. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.
Like most companies, Donaldson Company does come with some risks, and we've found 1 warning sign that you should be aware of.
While Donaldson Company 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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