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Did you know there are some financial metrics that can provide clues of a potential multi-bagger? One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing 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. Although, when we looked at Etherstack (ASX:ESK), it didn't seem to tick all of these boxes.
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. 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).
Therefore, Etherstack has an ROCE of 3.2%. Ultimately, that's a low return and it under-performs the Software industry average of 12%.
Check out our latest analysis for Etherstack
While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you'd like to look at how Etherstack has performed in the past in other metrics, you can view this free graph of Etherstack's past earnings, revenue and cash flow.
How Are Returns Trending?
In terms of Etherstack's historical ROCE movements, the trend isn't fantastic. To be more specific, ROCE has fallen from 36% over the last four years. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.
On a side note, Etherstack has done well to pay down 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. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.
The Bottom Line On Etherstack'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 Etherstack. And the stock has done incredibly well with a 106% return over the last five years, so long term investors are no doubt ecstatic with that result. So while the underlying trends could already be accounted for by investors, we still think this stock is worth looking into further.