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Arco Platform (NASDAQ:ARCE) Could Be Struggling To Allocate Capital

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If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base 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. However, after investigating Arco Platform (NASDAQ:ARCE), we don't think it's current trends fit the mold of a multi-bagger.

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 Arco Platform is:

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

0.037 = R$120m ÷ (R$4.5b - R$1.2b) (Based on the trailing twelve months to June 2021).

So, Arco Platform has an ROCE of 3.7%. Ultimately, that's a low return and it under-performs the Consumer Services industry average of 8.2%.

Check out our latest analysis for Arco Platform

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Above you can see how the current ROCE for Arco Platform compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

How Are Returns Trending?

Unfortunately, the trend isn't great with ROCE falling from 19% four years ago, while capital employed has grown 922%. Usually this isn't ideal, but given Arco Platform conducted a capital raising before their most recent earnings announcement, that would've likely contributed, at least partially, to the increased capital employed figure. The funds raised likely haven't been put to work yet so it's worth watching what happens in the future with Arco Platform's earnings and if they change as a result from the capital raise.

On a side note, Arco Platform's current liabilities have increased over the last four years to 28% of total assets, effectively distorting the ROCE to some degree. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. Keep an eye on this ratio, because the business could encounter some new risks if this metric gets too high.

The Bottom Line On Arco Platform's ROCE

Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Arco Platform. In light of this, the stock has only gained 0.5% over the last three years. Therefore we'd recommend looking further into this stock to confirm if it has the makings of a good investment.

Arco Platform does have some risks though, and we've spotted 1 warning sign for Arco Platform that you might be interested in.

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.

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

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