Etherstack (ASX:ESK) May Have Issues Allocating Its Capital

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing 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. In light of that, when we looked at Etherstack (ASX:ESK) and its ROCE trend, we weren't exactly thrilled.

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. 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$565k ÷ (US$16m - US$3.6m) (Based on the trailing twelve months to December 2023).

So, Etherstack has an ROCE of 4.5%. In absolute terms, that's a low return and it also under-performs the Software industry average of 10%.

See our latest analysis for Etherstack

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

So How Is Etherstack's ROCE Trending?

In terms of Etherstack's historical ROCE movements, the trend isn't fantastic. To be more specific, ROCE has fallen from 14% over the last five years. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.

On a side note, Etherstack has done well to pay down its current liabilities to 22% 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. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.

The Key Takeaway

In summary, Etherstack is reinvesting funds back into the business for growth but unfortunately it looks like sales haven't increased much just yet. And in the last five years, the stock has given away 37% 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.

Etherstack does come with some risks though, we found 4 warning signs in our investment analysis, and 2 of those are significant...

While Etherstack isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

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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.