If you're not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out for. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing 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. Having said that, from a first glance at Absolute Software (TSE:ABST) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.
Return On Capital Employed (ROCE): What is it?
Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Analysts use this formula to calculate it for Absolute Software:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.14 = US$15m ÷ (US$214m - US$110m) (Based on the trailing twelve months to December 2020).
Therefore, Absolute Software has an ROCE of 14%. By itself that's a normal return on capital and it's in line with the industry's average returns of 14%.
Above you can see how the current ROCE for Absolute Software 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.
How Are Returns Trending?
On the surface, the trend of ROCE at Absolute Software doesn't inspire confidence. Around five years ago the returns on capital were 35%, but since then they've fallen to 14%. However it looks like Absolute Software might be reinvesting for long term growth because while capital employed has increased, the company's sales haven't changed much in the last 12 months. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.
On a related note, Absolute Software has decreased its current liabilities to 52% of total assets. That could partly explain why the ROCE has dropped. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE. Keep in mind 52% is still pretty high, so those risks are still somewhat prevalent.
What We Can Learn From Absolute Software's ROCE
In summary, Absolute Software is reinvesting funds back into the business for growth but unfortunately it looks like sales haven't increased much just yet. Investors must think there's better things to come because the stock has knocked it out of the park, delivering a 233% gain to shareholders who have held over the last five years. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.
If you'd like to know about the risks facing Absolute Software, we've discovered 3 warning signs that you should be aware of.
While Absolute Software 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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