What underlying fundamental trends can indicate that a company might be in decline? Businesses in decline often have two underlying trends, firstly, a declining return on capital employed (ROCE) and a declining base of capital employed. Basically the company is earning less on its investments and it is also reducing its total assets. On that note, looking into Covanta Holding (NYSE:CVA), we weren't too upbeat about how things were going.
What is 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. To calculate this metric for Covanta Holding, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.027 = US$89m ÷ (US$3.6b - US$374m) (Based on the trailing twelve months to March 2021).
Therefore, Covanta Holding has an ROCE of 2.7%. Ultimately, that's a low return and it under-performs the Commercial Services industry average of 7.4%.
In the above chart we have measured Covanta Holding's prior ROCE against its prior performance, but the future is arguably more important. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Covanta Holding.
What The Trend Of ROCE Can Tell Us
We are a bit worried about the trend of returns on capital at Covanta Holding. Unfortunately the returns on capital have diminished from the 3.6% that they were earning five years ago. And on the capital employed front, the business is utilizing roughly the same amount of capital as it was back then. This combination can be indicative of a mature business that still has areas to deploy capital, but the returns received aren't as high due potentially to new competition or smaller margins. If these trends continue, we wouldn't expect Covanta Holding to turn into a multi-bagger.
Our Take On Covanta Holding's ROCE
All in all, the lower returns from the same amount of capital employed aren't exactly signs of a compounding machine. Despite the concerning underlying trends, the stock has actually gained 25% 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.
Covanta Holding does come with some risks though, we found 3 warning signs in our investment analysis, and 2 of those are a bit unpleasant...
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
If you’re looking to trade Covanta Holding, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade 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.