LSI Software (WSE:LSI) Could Be Struggling To Allocate 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. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. In light of that, when we looked at LSI Software (WSE:LSI) and its ROCE trend, we weren't exactly thrilled.

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 LSI Software:

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

0.012 = zł538k ÷ (zł54m - zł10m) (Based on the trailing twelve months to December 2020).

Thus, LSI Software has an ROCE of 1.2%. In absolute terms, that's a low return and it also under-performs the Software industry average of 13%.

See our latest analysis for LSI Software

Historical performance is a great place to start when researching a stock so above you can see the gauge for LSI Software's ROCE against it's prior returns. If you'd like to look at how LSI Software has performed in the past in other metrics, you can view this free graph of past earnings, revenue and cash flow.

What Can We Tell From LSI Software's ROCE Trend?

When we looked at the ROCE trend at LSI Software, we didn't gain much confidence. Over the last five years, returns on capital have decreased to 1.2% from 18% five years ago. Given the business is employing more capital while revenue has slipped, this is a bit concerning. If this were to continue, you might be looking at a company that is trying to reinvest for growth but is actually losing market share since sales haven't increased.

The Key Takeaway

From the above analysis, we find it rather worrisome that returns on capital and sales for LSI Software have fallen, meanwhile the business is employing more capital than it was five years ago. Yet despite these concerning fundamentals, the stock has performed strongly with a 59% return over the last five years, so investors appear very optimistic. In any case, the current underlying trends don't bode well for long term performance so unless they reverse, we'd start looking elsewhere.

One more thing, we've spotted 4 warning signs facing LSI Software that you might find interesting.

While LSI Software 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.

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