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To find a multi-bagger stock, what are the underlying trends we should look for in a business? Amongst other things, we'll want to see two things; firstly, a growing return on capital employed (ROCE) and secondly, an expansion in the company's 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. With that in mind, we've noticed some promising trends at Xero (ASX:XRO) so let's look a bit deeper.
Return On Capital Employed (ROCE): What is it?
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 Xero:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.033 = NZ$62m ÷ (NZ$2.0b - NZ$169m) (Based on the trailing twelve months to March 2021).
So, Xero has an ROCE of 3.3%. Ultimately, that's a low return and it under-performs the Software industry average of 14%.
In the above chart we have measured Xero'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 Xero here for free.
What The Trend Of ROCE Can Tell Us
We're delighted to see that Xero is reaping rewards from its investments and is now generating some pre-tax profits. The company was generating losses five years ago, but now it's earning 3.3% which is a sight for sore eyes. And unsurprisingly, like most companies trying to break into the black, Xero is utilizing 560% more capital than it was five years ago. This can tell us that the company has plenty of reinvestment opportunities that are able to generate higher returns.
The Bottom Line On Xero's ROCE
Long story short, we're delighted to see that Xero's reinvestment activities have paid off and the company is now profitable. And with the stock having performed exceptionally well over the last five years, these patterns are being accounted for by investors. Therefore, we think it would be worth your time to check if these trends are going to continue.
Xero does come with some risks though, we found 3 warning signs in our investment analysis, and 1 of those shouldn't be ignored...
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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