Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. 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. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. In light of that, when we looked at Ruth's Hospitality Group (NASDAQ:RUTH) and its ROCE trend, we weren't exactly thrilled.
What is 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. Analysts use this formula to calculate it for Ruth's Hospitality Group:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.082 = US$32m ÷ (US$503m - US$110m) (Based on the trailing twelve months to June 2021).
So, Ruth's Hospitality Group has an ROCE of 8.2%. Even though it's in line with the industry average of 7.9%, it's still a low return by itself.
In the above chart we have measured Ruth's Hospitality Group's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Ruth's Hospitality Group here for free.
What Can We Tell From Ruth's Hospitality Group's ROCE Trend?
When we looked at the ROCE trend at Ruth's Hospitality Group, we didn't gain much confidence. Around five years ago the returns on capital were 42%, but since then they've fallen to 8.2%. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.
On a side note, Ruth's Hospitality Group has done well to pay down its current liabilities to 22% of total assets. That could partly explain why the ROCE has dropped. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.
What We Can Learn From Ruth's Hospitality Group's ROCE
Bringing it all together, while we're somewhat encouraged by Ruth's Hospitality Group's reinvestment in its own business, we're aware that returns are shrinking. Although the market must be expecting these trends to improve because the stock has gained 47% over the last five years. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.
Like most companies, Ruth's Hospitality Group does come with some risks, and we've found 3 warning signs that you should be aware of.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
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.
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