What underlying fundamental trends can indicate that a company might be 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. This indicates to us that the business is not only shrinking the size of its net assets, but its returns are falling as well. On that note, looking into Alcoa (NYSE:AA), we weren’t too upbeat about how things were going.
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. To calculate this metric for Alcoa, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
0.034 = US$381m ÷ (US$13b – US$2.2b) (Based on the trailing twelve months to June 2020).
Thus, Alcoa has an ROCE of 3.4%. In absolute terms, that’s a low return and it also under-performs the Metals and Mining industry average of 8.0%.
In the above chart we have measured Alcoa’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 Alcoa.
So How Is Alcoa’s ROCE Trending?
The trend of ROCE at Alcoa is showing some signs of weakness. Unfortunately, returns have declined substantially over the last five years to the 3.4% we see today. What’s equally concerning is that the amount of capital deployed in the business has shrunk by 26% over that same period. The combination of lower ROCE and less capital employed can indicate that a business is likely to be facing some competitive headwinds or seeing an erosion to its moat. If these underlying trends continue, we wouldn’t be too optimistic going forward.
What We Can Learn From Alcoa’s ROCE
In summary, it’s unfortunate that Alcoa is shrinking its capital base and also generating lower returns. We expect this has contributed to the stock plummeting 70% during the last three years. With underlying trends that aren’t great in these areas, we’d consider looking elsewhere.
While Alcoa doesn’t shine too bright in this respect, it’s still worth seeing if the company is trading at attractive prices. You can find that out with our FREE intrinsic value estimation on our platform.
If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive returns on equity.
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.