If we’re looking to avoid a business that is in decline, what are the trends that can warn us ahead of time? 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. This indicates the company is producing less profit from its investments and its total assets are decreasing. So after we looked into Meridian Energy (NZSE:MEL), the trends above didn’t look too great.
Understanding 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. Analysts use this formula to calculate it for Meridian Energy:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
0.018 = NZ$168m ÷ (NZ$10b – NZ$1.0b) (Based on the trailing twelve months to December 2023).
So, Meridian Energy has an ROCE of 1.8%. Even though it’s in line with the industry average of 1.8%, it’s still a low return by itself.
Check out our latest analysis for Meridian Energy
In the above chart we have measured Meridian Energy’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 analyst report for Meridian Energy .
What The Trend Of ROCE Can Tell Us
In terms of Meridian Energy’s historical ROCE movements, the trend doesn’t inspire confidence. About five years ago, returns on capital were 5.9%, however they’re now substantially lower than that as we saw above. 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 Meridian Energy to turn into a multi-bagger.
Our Take On Meridian Energy’s ROCE
All in all, the lower returns from the same amount of capital employed aren’t exactly signs of a compounding machine. Yet despite these concerning fundamentals, the stock has performed strongly with a 66% return over the last five years, so investors appear very optimistic. In any case, the current underlying trends don’t bode well for long term performance so unless they reverse, we’d start looking elsewhere.
One more thing to note, we’ve identified 1 warning sign with Meridian Energy and understanding this should be part of your investment process.
While Meridian Energy 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.
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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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com
