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Returns On Capital Signal Tricky Times Ahead For SDI (ASX:SDI)

If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing amount of capital employed. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. However, after briefly looking over the numbers, we don't think SDI (ASX:SDI) has the makings of a multi-bagger going forward, but let's have a look at why that may be.

Understanding Return On Capital Employed (ROCE)

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. To calculate this metric for SDI, this is the formula:

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

0.088 = AU$7.0m ÷ (AU$89m - AU$9.0m) (Based on the trailing twelve months to December 2020).

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Thus, SDI has an ROCE of 8.8%. On its own that's a low return on capital but it's in line with the industry's average returns of 8.8%.

Check out our latest analysis for SDI

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While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you're interested in investigating SDI's past further, check out this free graph of past earnings, revenue and cash flow.

So How Is SDI's ROCE Trending?

In terms of SDI's historical ROCE movements, the trend isn't fantastic. Around five years ago the returns on capital were 15%, but since then they've fallen to 8.8%. Given the business is employing more capital while revenue has slipped, this is a bit concerning. If this were to continue, you might be looking at a company that is trying to reinvest for growth but is actually losing market share since sales haven't increased.

Our Take On SDI's ROCE

From the above analysis, we find it rather worrisome that returns on capital and sales for SDI have fallen, meanwhile the business is employing more capital than it was five years ago. The market must be rosy on the stock's future because even though the underlying trends aren't too encouraging, the stock has soared 116%. In any case, the current underlying trends don't bode well for long term performance so unless they reverse, we'd start looking elsewhere.

Since virtually every company faces some risks, it's worth knowing what they are, and we've spotted 3 warning signs for SDI (of which 1 is a bit unpleasant!) that you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.