Cogstate (ASX:CGS) Is Looking To Continue Growing Its Returns On Capital

What trends should we look for it we want to identify stocks that can multiply in value over the long term? 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. So when we looked at Cogstate (ASX:CGS) and its trend of ROCE, we really liked what we saw.

Understanding 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. To calculate this metric for Cogstate, this is the formula:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.074 = US$2.1m ÷ (US$47m - US$19m) (Based on the trailing twelve months to December 2020).

Thus, Cogstate has an ROCE of 7.4%. In absolute terms, that's a low return and it also under-performs the Healthcare Services industry average of 9.6%.

See our latest analysis for Cogstate

Historical performance is a great place to start when researching a stock so above you can see the gauge for Cogstate's ROCE against it's prior returns. If you're interested in investigating Cogstate's past further, check out this free graph of past earnings, revenue and cash flow.

What Can We Tell From Cogstate's ROCE Trend?

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 7.4%. The amount of capital employed has increased too, by 180%. The increasing returns on a growing amount of capital is common amongst multi-baggers and that's why we're impressed.

For the record though, there was a noticeable increase in the company's current liabilities over the period, so we would attribute some of the ROCE growth to that. Essentially the business now has suppliers or short-term creditors funding about 40% of its operations, which isn't ideal. Keep an eye out for future increases because when the ratio of current liabilities to total assets gets particularly high, this can introduce some new risks for the business.

The Bottom Line On Cogstate's ROCE

All in all, it's terrific to see that Cogstate is reaping the rewards from prior investments and is growing its capital base. And a remarkable 128% total return over the last five years tells us that investors are expecting more good things to come in the future. 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.

On a separate note, we've found 2 warning signs for Cogstate you'll probably want to know about.

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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