Returns Are Gaining Momentum At Xero (ASX:XRO)

If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. 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. Speaking of which, we noticed some great changes in Xero's (ASX:XRO) returns on capital, so let's have a 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 Xero is:

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%. In absolute terms, that's a low return and it also under-performs the Software industry average of 13%.

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 to see what analysts are forecasting going forward, you should check out our free analyst report for Xero .

So How Is Xero's ROCE Trending?

We're glad to see that ROCE is heading in the right direction, even if it is still low at the moment. 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. So we're very much inspired by what we're seeing at Xero thanks to its ability to profitably reinvest capital.

The Key Takeaway

In summary, it's great to see that Xero can compound returns by consistently reinvesting capital at increasing rates of return, because these are some of the key ingredients of those highly sought after multi-baggers. Since the stock has returned a staggering 114% to shareholders over the last five years, it looks like investors are recognizing these changes. Therefore, we think it would be worth your time to check if these trends are going to continue.

While Xero looks impressive, no company is worth an infinite price. The intrinsic value infographic for XRO helps visualize whether it is currently trading for a fair price.

While Xero 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.