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. 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)
0.033 = 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 14%.
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 report for Xero.
What The Trend Of ROCE Can Tell Us
The fact that Xero is now generating some pre-tax profits from its prior investments is very encouraging. About five years ago the company was generating losses but things have turned around because it's now earning 3.3% on its capital. And unsurprisingly, like most companies trying to break into the black, Xero is utilizing 560% more capital than it was five years ago. This can tell us that the company has plenty of reinvestment opportunities that are able to generate higher returns.
Our Take On Xero's ROCE
To the delight of most shareholders, Xero has now broken into profitability. And with the stock having performed exceptionally well over the last five years, these patterns are being accounted for by investors. Therefore, we think it would be worth your time to check if these trends are going to continue.
One more thing: We've identified 3 warning signs with Xero (at least 1 which can't be ignored) , and understanding them would certainly be useful.
While Xero may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.
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