Capital Allocation Trends At Cato (NYSE:CATO) Aren't Ideal

When researching a stock for investment, what can tell us that the company is in decline? A business that's potentially in decline often shows two trends, a return on capital employed (ROCE) that's declining, and a base of capital employed that's also declining. Trends like this ultimately mean the business is reducing its investments and also earning less on what it has invested. And from a first read, things don't look too good at Cato (NYSE:CATO), so let's see why.

Return On Capital Employed (ROCE): What Is It?

For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. Analysts use this formula to calculate it for Cato:

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

0.026 = US$9.5m ÷ (US$561m - US$199m) (Based on the trailing twelve months to July 2022).

Thus, Cato has an ROCE of 2.6%. In absolute terms, that's a low return and it also under-performs the Specialty Retail industry average of 17%.

Our analysis indicates that CATO is potentially undervalued!

Historical performance is a great place to start when researching a stock so above you can see the gauge for Cato's ROCE against it's prior returns. If you're interested in investigating Cato's past further, check out this free graph of past earnings, revenue and cash flow.

What The Trend Of ROCE Can Tell Us

There is reason to be cautious about Cato, given the returns are trending downwards. About five years ago, returns on capital were 3.3%, 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. Since returns are falling and the business has the same amount of assets employed, this can suggest it's a mature business that hasn't had much growth in the last five years. If these trends continue, we wouldn't expect Cato to turn into a multi-bagger.

On a side note, Cato's current liabilities have increased over the last five years to 36% of total assets, effectively distorting the ROCE to some degree. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. Keep an eye on this ratio, because the business could encounter some new risks if this metric gets too high.

Our Take On Cato's ROCE

All in all, the lower returns from the same amount of capital employed aren't exactly signs of a compounding machine. Investors must expect better things on the horizon though because the stock has risen 4.8% in the last five years. Either way, we aren't huge fans of the current trends and so with that we think you might find better investments elsewhere.

If you'd like to know more about Cato, we've spotted 4 warning signs, and 3 of them make us uncomfortable.

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.

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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.