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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? Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base 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. So on that note, Xero (ASX:XRO) looks quite promising in regards to its trends of return on capital.
Understanding Return On Capital Employed (ROCE)
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. Analysts use this formula to calculate it for Xero:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.096 = NZ$259m ÷ (NZ$3.0b - NZ$264m) (Based on the trailing twelve months to March 2024).
So, Xero has an ROCE of 9.6%. On its own that's a low return on capital but it's in line with the industry's average returns of 9.8%.
Check out our latest analysis for Xero
Above you can see how the current ROCE for Xero compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Xero for free.
So How Is Xero's ROCE Trending?
Even though ROCE is still low in absolute terms, it's good to see it's heading in the right direction. The numbers show that in the last five years, the returns generated on capital employed have grown considerably to 9.6%. Basically the business is earning more per dollar of capital invested and in addition to that, 211% more capital is being employed now too. The increasing returns on a growing amount of capital is common amongst multi-baggers and that's why we're impressed.
The Key Takeaway
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 with the stock having performed exceptionally well over the last five years, these patterns are being accounted for by investors. In light of that, we think it's worth looking further into this stock because if Xero can keep these trends up, it could have a bright future ahead.
Before jumping to any conclusions though, we need to know what value we're getting for the current share price. That's where you can check out our FREE intrinsic value estimation for XRO that compares the share price and estimated value.