Be Wary Of Etherstack (ASX:ESK) And Its Returns On Capital

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base 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. Having said that, from a first glance at Etherstack (ASX:ESK) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.

What Is Return On Capital Employed (ROCE)?

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. The formula for this calculation on Etherstack is:

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

0.045 = US$564k ÷ (US$16m - US$3.9m) (Based on the trailing twelve months to December 2023).

Therefore, Etherstack has an ROCE of 4.5%. Ultimately, that's a low return and it under-performs the Software industry average of 13%.

Check out our latest analysis for Etherstack

Above you can see how the current ROCE for Etherstack 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 Etherstack for free.

How Are Returns Trending?

When we looked at the ROCE trend at Etherstack, we didn't gain much confidence. Over the last five years, returns on capital have decreased to 4.5% from 14% five years ago. However it looks like Etherstack might be reinvesting for long term growth because while capital employed has increased, the company's sales haven't changed much in the last 12 months. It may take some time before the company starts to see any change in earnings from these investments.

On a related note, Etherstack has decreased its current liabilities to 24% of total assets. Since the ratio used to be 98%, that's a significant reduction and it no doubt explains the drop 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.

What We Can Learn From Etherstack's ROCE

Bringing it all together, while we're somewhat encouraged by Etherstack's reinvestment in its own business, we're aware that returns are shrinking. And in the last five years, the stock has given away 15% so the market doesn't look too hopeful on these trends strengthening any time soon. Therefore based on the analysis done in this article, we don't think Etherstack has the makings of a multi-bagger.

One final note, you should learn about the 4 warning signs we've spotted with Etherstack (including 1 which doesn't sit too well with us) .

If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive 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.