Computer Modelling Group (TSE:CMG) May Have Issues Allocating Its Capital

To find a multi-bagger stock, what are the underlying trends we should look for in a business? One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing amount 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. So when we looked at Computer Modelling Group (TSE:CMG), they do have a high ROCE, but we weren't exactly elated from how returns are trending.

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

For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. Analysts use this formula to calculate it for Computer Modelling Group:

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

0.33 = CA$31m ÷ (CA$130m - CA$36m) (Based on the trailing twelve months to June 2023).

Thus, Computer Modelling Group has an ROCE of 33%. In absolute terms that's a great return and it's even better than the Software industry average of 8.9%.

View our latest analysis for Computer Modelling Group

In the above chart we have measured Computer Modelling Group'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.

What Can We Tell From Computer Modelling Group's ROCE Trend?

When we looked at the ROCE trend at Computer Modelling Group, we didn't gain much confidence. To be more specific, while the ROCE is still high, it's fallen from 47% where it was five years ago. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. If these investments prove successful, this can bode very well for long term stock performance.

On a related note, Computer Modelling Group has decreased its current liabilities to 28% of total assets. So we could link some of this to the decrease in ROCE. 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. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.

Our Take On Computer Modelling Group's ROCE

Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Computer Modelling Group. These trends are starting to be recognized by investors since the stock has delivered a 13% gain to shareholders who've held over the last five years. Therefore we'd recommend looking further into this stock to confirm if it has the makings of a good investment.

If you'd like to know about the risks facing Computer Modelling Group, we've discovered 1 warning sign that you should be aware of.

If you'd like to see other companies earning high returns, check out our free list of companies earning high returns with solid balance sheets here.

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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.