Be Wary Of Megasoft (NSE:MEGASOFT) And Its Returns On Capital

What trends should we look for it we want to identify stocks that can multiply in value over the long term? Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base 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. In light of that, when we looked at Megasoft (NSE:MEGASOFT) and its ROCE trend, we weren't exactly thrilled.

What is 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. To calculate this metric for Megasoft, this is the formula:

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

0.0048 = ₹7.8m ÷ (₹3.2b - ₹1.5b) (Based on the trailing twelve months to March 2021).

Thus, Megasoft has an ROCE of 0.5%. Ultimately, that's a low return and it under-performs the Software industry average of 13%.

View our latest analysis for Megasoft

While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you want to delve into the historical earnings, revenue and cash flow of Megasoft, check out these free graphs here.

How Are Returns Trending?

When we looked at the ROCE trend at Megasoft, we didn't gain much confidence. Over the last five years, returns on capital have decreased to 0.5% from 6.8% five years ago. However it looks like Megasoft 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 may take some time before the company starts to see any change in earnings from these investments.

On a side note, Megasoft's current liabilities are still rather high at 49% 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.

The Bottom Line On Megasoft's ROCE

Bringing it all together, while we're somewhat encouraged by Megasoft's reinvestment in its own business, we're aware that returns are shrinking. And in the last five years, the stock has given away 14% so the market doesn't look too hopeful on these trends strengthening any time soon. All in all, the inherent trends aren't typical of multi-baggers, so if that's what you're after, we think you might have more luck elsewhere.

One more thing: We've identified 3 warning signs with Megasoft (at least 2 which are a bit concerning) , and understanding these would certainly be useful.

While Megasoft isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

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