There Are Reasons To Feel Uneasy About NEXTDC's (ASX:NXT) Returns On Capital

What are the early trends we should look for to identify a stock that could multiply in value over the long term? 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. In light of that, when we looked at NEXTDC (ASX:NXT) and its ROCE trend, we weren't exactly thrilled.

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 NEXTDC is:

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

0.013 = AU$50m ÷ (AU$3.8b - AU$92m) (Based on the trailing twelve months to June 2023).

Thus, NEXTDC has an ROCE of 1.3%. In absolute terms, that's a low return and it also under-performs the IT industry average of 16%.

Check out our latest analysis for NEXTDC

Above you can see how the current ROCE for NEXTDC compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

What Does the ROCE Trend For NEXTDC Tell Us?

On the surface, the trend of ROCE at NEXTDC doesn't inspire confidence. Over the last five years, returns on capital have decreased to 1.3% from 2.3% five years ago. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. If these investments prove successful, this can bode very well for long term stock performance.

What We Can Learn From NEXTDC's ROCE

In summary, despite lower returns in the short term, we're encouraged to see that NEXTDC is reinvesting for growth and has higher sales as a result. And the stock has done incredibly well with a 102% return over the last five years, so long term investors are no doubt ecstatic with that result. So while the underlying trends could already be accounted for by investors, we still think this stock is worth looking into further.

One final note, you should learn about the 3 warning signs we've spotted with NEXTDC (including 1 which is concerning) .

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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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.