What are the early trends we should look for to identify a stock that could multiply in value over the long term? 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. 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 ran our eye over Constellation Software's (TSE:CSU) trend of ROCE, we really liked what we saw.
Understanding Return On Capital Employed (ROCE)
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. The formula for this calculation on Constellation Software is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.30 = US$623m ÷ (US$3.9b - US$1.8b) (Based on the trailing twelve months to September 2020).
Therefore, Constellation Software has an ROCE of 30%. That's a fantastic return and not only that, it outpaces the average of 19% earned by companies in a similar industry.
Above you can see how the current ROCE for Constellation Software 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 Constellation Software.
How Are Returns Trending?
Constellation Software deserves to be commended in regards to it's returns. The company has consistently earned 30% for the last five years, and the capital employed within the business has risen 141% in that time. Returns like this are the envy of most businesses and given it has repeatedly reinvested at these rates, that's even better. If these trends can continue, it wouldn't surprise us if the company became a multi-bagger.On a side note, Constellation Software's current liabilities are still rather high at 47% of total assets. This effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.
What We Can Learn From Constellation Software's ROCE
Constellation Software has demonstrated its proficiency by generating high returns on increasing amounts of capital employed, which we're thrilled about. And long term investors would be thrilled with the 236% return they've received over the last five years. So while the positive underlying trends may be accounted for by investors, we still think this stock is worth looking into further.
If you'd like to know about the risks facing Constellation Software, we've discovered 1 warning sign that you should be aware of.
Constellation Software is not the only stock earning high returns. If you'd like to see more, check out our free list of companies earning high returns on equity with solid fundamentals.
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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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