When we're researching a company, it's sometimes hard to find the warning signs, but there are some financial metrics that can help spot trouble early. 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. On that note, looking into Mercury NZ (NZSE:MCY), we weren't too upbeat about how things were going.
Understanding Return On Capital Employed (ROCE)
For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. The formula for this calculation on Mercury NZ is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.044 = NZ$256m ÷ (NZ$6.4b - NZ$633m) (Based on the trailing twelve months to December 2019).
So, Mercury NZ has an ROCE of 4.5%. On its own that's a low return on capital but it's in line with the industry's average returns of 4.5%.
Above you can see how the current ROCE for Mercury NZ compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Mercury NZ here for free.
The Trend Of ROCE
In terms of Mercury NZ's historical ROCE movements, the trend doesn't inspire confidence. About five years ago, returns on capital were 6.0%, 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. If these trends continue, we wouldn't expect Mercury NZ to turn into a multi-bagger.
The Bottom Line
In summary, it's unfortunate that Mercury NZ is generating lower returns from the same amount of capital. Yet despite these poor fundamentals, the stock has gained a huge 144% over the last five years, so investors appear very optimistic. Regardless, we don't feel to comfortable with the fundamentals so we'd be steering clear of this stock for now.
If you want to know some of the risks facing Mercury NZ we've found 3 warning signs (1 is significant!) that you should be aware of before investing here.
While Mercury NZ 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.
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.
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