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. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. Although, when we looked at Zedge (NYSEMKT:ZDGE), it didn't seem to tick all of these boxes.
Understanding Return On Capital Employed (ROCE)
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 Zedge:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.14 = US$1.4m ÷ (US$13m - US$3.3m) (Based on the trailing twelve months to October 2020).
Therefore, Zedge has an ROCE of 14%. In absolute terms, that's a satisfactory return, but compared to the Interactive Media and Services industry average of 9.2% it's much better.
In the above chart we have measured Zedge's prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.
How Are Returns Trending?
In terms of Zedge's historical ROCE movements, the trend isn't fantastic. To be more specific, ROCE has fallen from 28% over the last five years. 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. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Zedge. And the stock has done incredibly well with a 133% return over the last three years, so long term investors are no doubt ecstatic with that result. So while the underlying trends could already be accounted for by investors, we still think this stock is worth looking into further.
One more thing to note, we've identified 3 warning signs with Zedge and understanding them should be part of your investment process.
While Zedge 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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