To avoid investing in a business that's in decline, there's a few financial metrics that can provide early indications of aging. Businesses in decline often have two underlying trends, firstly, a declining return on capital employed (ROCE) and a declining base of capital employed. This reveals that the company isn't compounding shareholder wealth because returns are falling and its net asset base is shrinking. And from a first read, things don't look too good at Kennametal (NYSE:KMT), so let's see why.
Understanding Return On Capital Employed (ROCE)
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. The formula for this calculation on Kennametal is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.094 = US$199m ÷ (US$2.5b - US$434m) (Based on the trailing twelve months to June 2023).
So, Kennametal has an ROCE of 9.4%. On its own, that's a low figure but it's around the 12% average generated by the Machinery industry.
View our latest analysis for Kennametal
Above you can see how the current ROCE for Kennametal compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Kennametal.
What The Trend Of ROCE Can Tell Us
We are a bit worried about the trend of returns on capital at Kennametal. About five years ago, returns on capital were 16%, 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. Since returns are falling and the business has the same amount of assets employed, this can suggest it's a mature business that hasn't had much growth in the last five years. So because these trends aren't typically conducive to creating a multi-bagger, we wouldn't hold our breath on Kennametal becoming one if things continue as they have.
On a side note, Kennametal has done well to pay down its current liabilities to 17% of total assets. That could partly explain why the ROCE has dropped. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.
The Key Takeaway
All in all, the lower returns from the same amount of capital employed aren't exactly signs of a compounding machine. It should come as no surprise then that the stock has fallen 30% over the last five years, so it looks like investors are recognizing these changes. That being the case, unless the underlying trends revert to a more positive trajectory, we'd consider looking elsewhere.
Like most companies, Kennametal does come with some risks, and we've found 1 warning sign that you should be aware of.
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.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.
