Returns On Capital Are Showing Encouraging Signs At Xero (ASX:XRO)

If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. In a perfect world, we'd like to see a company investing more capital into its business and ideally the returns earned from that capital are also increasing. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. So on that note, Xero (ASX:XRO) looks quite promising in regards to its trends of return on capital.

Understanding Return On Capital Employed (ROCE)

For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. Analysts use this formula to calculate it for Xero:

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

0.033 = NZ$62m ÷ (NZ$2.0b - NZ$169m) (Based on the trailing twelve months to March 2021).

Thus, Xero has an ROCE of 3.3%. In absolute terms, that's a low return and it also under-performs the Software industry average of 11%.

View 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're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

What Can We Tell From Xero's ROCE Trend?

We're delighted to see that Xero is reaping rewards from its investments and is now generating some pre-tax profits. The company was generating losses five years ago, but now it's earning 3.3% which is a sight for sore eyes. In addition to that, Xero is employing 560% more capital than previously which is expected of a company that's trying to break into profitability. We like this trend, because it tells us the company has profitable reinvestment opportunities available to it, and if it continues going forward that can lead to a multi-bagger performance.

The Key Takeaway

In summary, it's great to see that Xero has managed to break into profitability and is continuing to reinvest in its business. Since the stock has returned a staggering 834% to shareholders over the last five years, it looks like investors are recognizing these changes. 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.

Since virtually every company faces some risks, it's worth knowing what they are, and we've spotted 4 warning signs for Xero (of which 1 is concerning!) that you should 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.

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.

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