If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? 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. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. Ergo, when we looked at the ROCE trends at Microware Group (HKG:1985), we 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. Analysts use this formula to calculate it for Microware Group:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.27 = HK$57m ÷ (HK$467m - HK$253m) (Based on the trailing twelve months to September 2020).
Thus, Microware Group has an ROCE of 27%. In absolute terms that's a great return and it's even better than the IT industry average of 7.6%.
Historical performance is a great place to start when researching a stock so above you can see the gauge for Microware Group's ROCE against it's prior returns. If you're interested in investigating Microware Group's past further, check out this free graph of past earnings, revenue and cash flow.
What Can We Tell From Microware Group's ROCE Trend?
In terms of Microware Group's history of ROCE, it's quite impressive. Over the past five years, ROCE has remained relatively flat at around 27% and the business has deployed 61% more capital into its operations. Returns like this are the envy of most businesses and given it has repeatedly reinvested at these rates, that's even better. If Microware Group can keep this up, we'd be very optimistic about its future.
On a side note, Microware Group has done well to reduce current liabilities to 54% of total assets over the last five years. This can eliminate some of the risks inherent in the operations because the business has less outstanding obligations to their suppliers and or short-term creditors than they did previously. Although because current liabilities are still 54%, some of that risk is still prevalent.
What We Can Learn From Microware Group's ROCE
In summary, we're delighted to see that Microware Group has been compounding returns by reinvesting at consistently high rates of return, as these are common traits of a multi-bagger. However, over the last three years, the stock hasn't provided much growth to shareholders in the way of total returns. That's why we think it'd be worthwhile to look further into this stock given the fundamentals are appealing.
One more thing to note, we've identified 2 warning signs with Microware Group and understanding them should be part of your investment process.
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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