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If we want to find a stock that could multiply over the long term, what are the underlying trends we should look 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. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. So when we looked at Xero (ASX:XRO) and its trend of ROCE, we really liked what we saw.
What Is Return On Capital Employed (ROCE)?
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)
0.18 = NZ$366m ÷ (NZ$3.9b - NZ$1.9b) (Based on the trailing twelve months to September 2024).
Therefore, Xero has an ROCE of 18%. On its own, that's a standard return, however it's much better than the 14% generated by the Software industry.
See our latest analysis for Xero
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 to see what analysts are forecasting going forward, you should check out our free analyst report for Xero .
What Can We Tell From Xero's ROCE Trend?
Xero is displaying some positive trends. The numbers show that in the last five years, the returns generated on capital employed have grown considerably to 18%. The amount of capital employed has increased too, by 117%. The increasing returns on a growing amount of capital is common amongst multi-baggers and that's why we're impressed.
On a side note, we noticed that the improvement in ROCE appears to be partly fueled by an increase in current liabilities. The current liabilities has increased to 48% of total assets, so the business is now more funded by the likes of its suppliers or short-term creditors. Given it's pretty high ratio, we'd remind investors that having current liabilities at those levels can bring about some risks in certain businesses.
In Conclusion...
A company that is growing its returns on capital and can consistently reinvest in itself is a highly sought after trait, and that's what Xero has. And investors seem to expect more of this going forward, since the stock has rewarded shareholders with a 82% return over the last five years. With that being said, we still think the promising fundamentals mean the company deserves some further due diligence.