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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.