Xero (ASX:XRO) Might Have The Makings Of A Multi-Bagger

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. So on that note, Xero (ASX:XRO) looks quite promising in regards to its trends of return on capital.

Return On Capital Employed (ROCE): What Is It?

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)

0.032 = NZ$69m ÷ (NZ$2.3b - NZ$196m) (Based on the trailing twelve months to March 2022).

Therefore, Xero has an ROCE of 3.2%. In absolute terms, that's a low return and it also under-performs the Software industry average of 13%.

See 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 Does the ROCE Trend For Xero Tell Us?

We're delighted to see that Xero is reaping rewards from its investments and is now generating some pre-tax profits. About five years ago the company was generating losses but things have turned around because it's now earning 3.2% on its capital. In addition to that, Xero is employing 844% more capital than previously which is expected of a company that's trying to break into profitability. This can tell us that the company has plenty of reinvestment opportunities that are able to generate higher returns.

On a related note, the company's ratio of current liabilities to total assets has decreased to 8.4%, which basically reduces it's funding from the likes of short-term creditors or suppliers. Therefore we can rest assured that the growth in ROCE is a result of the business' fundamental improvements, rather than a cooking class featuring this company's books.

In Conclusion...

In summary, it's great to see that Xero has managed to break into profitability and is continuing to reinvest in its business. And a remarkable 296% total return over the last five years tells us that investors are expecting more good things to come in the future. In light of that, we think it's worth looking further into this stock because if Xero can keep these trends up, it could have a bright future ahead.

Before jumping to any conclusions though, we need to know what value we're getting for the current share price. That's where you can check out our FREE intrinsic value estimation that compares the share price and estimated value.

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.