What We Make Of Xero's (ASX:XRO) 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? 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. With that in mind, we've noticed some promising trends at Xero (ASX:XRO) so let's look a bit deeper.

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. To calculate this metric for Xero, this is the formula:

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

0.059 = NZ$78m ÷ (NZ$1.4b - NZ$107m) (Based on the trailing twelve months to September 2020).

So, Xero has an ROCE of 5.9%. Ultimately, that's a low return and it under-performs the Software industry average of 13%.

Check out our latest analysis for Xero

In the above chart we have measured Xero's prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

So How Is Xero's ROCE Trending?

The fact that Xero is now generating some pre-tax profits from its prior investments is very encouraging. The company was generating losses five years ago, but now it's earning 5.9% which is a sight for sore eyes. Not only that, but the company is utilizing 314% more capital than before, but that's to be expected from a company 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.

What We Can Learn From Xero's ROCE

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 690% 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.

On a final note, we've found 4 warning signs for Xero that we think you should be aware of.

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. 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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