Be Wary Of ServerworksLtd (TSE:4434) And Its Returns On Capital

There are a few key trends to look for if we want to identify the next multi-bagger. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount 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 ServerworksLtd (TSE:4434) and its ROCE trend, we weren't exactly thrilled.

This technology could replace computers: discover the 20 stocks are working to make quantum computing a reality.

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 ServerworksLtd:

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

0.083 = JP¥1.0b ÷ (JP¥20b - JP¥8.2b) (Based on the trailing twelve months to November 2024).

Thus, ServerworksLtd has an ROCE of 8.3%. Ultimately, that's a low return and it under-performs the IT industry average of 16%.

Check out our latest analysis for ServerworksLtd

In the above chart we have measured ServerworksLtd's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering ServerworksLtd for free.

What Does the ROCE Trend For ServerworksLtd Tell Us?

On the surface, the trend of ROCE at ServerworksLtd doesn't inspire confidence. Around five years ago the returns on capital were 13%, but since then they've fallen to 8.3%. 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.

While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 40%, which has impacted the ROCE. Without this increase, it's likely that ROCE would be even lower than 8.3%. What this means is that in reality, a rather large portion of the business is being funded by the likes of the company's suppliers or short-term creditors, which can bring some risks of its own.

The Bottom Line On ServerworksLtd's ROCE

In summary, despite lower returns in the short term, we're encouraged to see that ServerworksLtd is reinvesting for growth and has higher sales as a result. But since the stock has dived 76% in the last five years, there could be other drivers that are influencing the business' outlook. Regardless, reinvestment can pay off in the long run, so we think astute investors may want to look further into this stock.

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

While ServerworksLtd 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.