Etherstack's (ASX:ESK) Returns On Capital Not Reflecting Well On The Business
If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. However, after investigating Etherstack (ASX:ESK), we don't think it's current trends fit the mold of a multi-bagger.
What Is 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. To calculate this metric for Etherstack, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.032 = US$360k ÷ (US$15m - US$3.4m) (Based on the trailing twelve months to June 2024).
So, Etherstack has an ROCE of 3.2%. In absolute terms, that's a low return and it also under-performs the Software industry average of 9.8%.
See our latest analysis for Etherstack
Historical performance is a great place to start when researching a stock so above you can see the gauge for Etherstack's ROCE against it's prior returns. If you want to delve into the historical earnings , check out these free graphs detailing revenue and cash flow performance of Etherstack.
What Can We Tell From Etherstack's ROCE Trend?
On the surface, the trend of ROCE at Etherstack doesn't inspire confidence. Over the last four years, returns on capital have decreased to 3.2% from 36% four years ago. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.
On a related note, Etherstack has decreased its current liabilities to 23% of total assets. Considering it used to be 80%, that's a huge drop in that ratio and it would explain the decline in ROCE. 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. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.
In Conclusion...
While returns have fallen for Etherstack in recent times, we're encouraged to see that sales are growing and that the business is reinvesting in its operations. And there could be an opportunity here if other metrics look good too, because the stock has declined 33% in the last five years. As a result, we'd recommend researching this stock further to uncover what other fundamentals of the business can show us.
One more thing to note, we've identified 2 warning signs with Etherstack and understanding these should be part of your investment process.
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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.