Capital Allocation Trends At Telefónica (BME:TEF) Aren’t Ideal

What underlying fundamental trends can indicate that a company might be in decline? 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 Telefónica (BME: TEF), we weren’t too upbeat about how things were going.

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 Telefónica, this is the formula:

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

0.027 = € 2.3b ÷ (€ 109b – € 25b) (Based on the trailing twelve months to December 2021).

I know, Telefónica has an ROCE of 2.7%. In absolute terms, that’s a low return and it also under-performs the Telecom industry average of 9.0%.

Check out our latest analysis for Telefónica

BME: TEF Return on Capital Employed March 18th 2022

In the above chart we have measured Telefónica’s prior ROCE against its prior performance, but the future is arguably more important. If you’re interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

What Does the ROCE Trend For Telefónica Tell Us?

We are a bit worried about the trend of returns on capital at Telefónica. To be more specific, the ROCE was 7.6% five years ago, but since then it has dropped noticeably. On top of that, it’s worth noting that the amount of capital employed within the business has remained relatively steady. 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. If these trends continue, we wouldn’t expect Telefónica to turn into a multi-bagger.

What We Can Learn From Telefónica’s ROCE

All in all, the lower returns from the same amount of capital employed aren’t exactly signs of a compounding machine. Investors haven’t taken kindly to these developments, since the stock has declined 48% from where it was five years ago. That being the case, unless the underlying trends revert to a more positive trajectory, we’d consider looking elsewhere.

Telefónica does have some risks, we noticed 5 warning signs (and 2 which are concerning) we think you should know about.

While Telefónica may not currently earn the highest returns, we’ve compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.

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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