If you're not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out for. 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 that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. The formula for this calculation on Xero is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.035 = NZ$82m ÷ (NZ$2.6b - NZ$237m) (Based on the trailing twelve months to September 2022).
Therefore, Xero has an ROCE of 3.5%. In absolute terms, that's a low return and it also under-performs the Software industry average of 9.3%.
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 Does the ROCE Trend For Xero Tell Us?
The fact that Xero is now generating some pre-tax profits from its prior investments is very encouraging. The company was generating losses five years ago, but now it's earning 3.5% which is a sight for sore eyes. And unsurprisingly, like most companies trying to break into the black, Xero is utilizing 953% more capital than it was five years ago. We like this trend, because it tells us the company has profitable reinvestment opportunities available to it, and if it continues going forward that can lead to a multi-bagger performance.
On a related note, the company's ratio of current liabilities to total assets has decreased to 9.2%, which basically reduces it's funding from the likes of short-term creditors or suppliers. So this improvement in ROCE has come from the business' underlying economics, which is great to see.
The Key Takeaway
Overall, Xero gets a big tick from us thanks in most part to the fact that it is now profitable and is reinvesting in its business. And with the stock having performed exceptionally well over the last five years, these patterns are being accounted for by investors. So given the stock has proven it has promising trends, it's worth researching the company further to see if these trends are likely to persist.
While Xero looks impressive, no company is worth an infinite price. The intrinsic value infographic in our free research report helps visualize whether XRO is currently trading for a fair price.
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.
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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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