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To avoid investing in a business that's in decline, there's a few financial metrics that can provide early indications of aging. More often than not, we'll see a declining return on capital employed (ROCE) and a declining amount of capital employed. Trends like this ultimately mean the business is reducing its investments and also earning less on what it has invested. On that note, looking into Domtar (NYSE:UFS), we weren't too upbeat about how things were going.
What is 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 Domtar:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.026 = US$85m ÷ (US$4.1b - US$844m) (Based on the trailing twelve months to March 2021).
So, Domtar has an ROCE of 2.6%. In absolute terms, that's a low return and it also under-performs the Forestry industry average of 10%.
In the above chart we have measured Domtar'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 Domtar.
How Are Returns Trending?
The trend of ROCE at Domtar is showing some signs of weakness. Unfortunately, returns have declined substantially over the last five years to the 2.6% we see today. What's equally concerning is that the amount of capital deployed in the business has shrunk by 34% 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.
The Bottom Line On Domtar's ROCE
In summary, it's unfortunate that Domtar is shrinking its capital base and also generating lower returns. However the stock has delivered a 84% return to shareholders over the last five years, so investors might be expecting the trends to turn around. In any case, the current underlying trends don't bode well for long term performance so unless they reverse, we'd start looking elsewhere.
If you want to continue researching Domtar, you might be interested to know about the 1 warning sign that our analysis has discovered.
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.
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