Open Text's (NASDAQ:OTEX) Returns On Capital Not Reflecting Well On The Business

To find a multi-bagger stock, what are the underlying trends we should look for in a business? Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding 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 Open Text (NASDAQ:OTEX) and its ROCE trend, we weren't exactly thrilled.

What Is Return On Capital Employed (ROCE)?

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Analysts use this formula to calculate it for Open Text:

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

0.054 = US$744m ÷ (US$17b - US$2.8b) (Based on the trailing twelve months to September 2023).

Thus, Open Text has an ROCE of 5.4%. In absolute terms, that's a low return and it also under-performs the Software industry average of 7.6%.

See our latest analysis for Open Text

In the above chart we have measured Open Text'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 Open Text here for free.

The Trend Of ROCE

In terms of Open Text's historical ROCE movements, the trend isn't fantastic. Over the last five years, returns on capital have decreased to 5.4% from 8.2% five years ago. 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.

The Bottom Line

Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Open Text. In light of this, the stock has only gained 29% over the last five years. So this stock may still be an appealing investment opportunity, if other fundamentals prove to be sound.

One final note, you should learn about the 3 warning signs we've spotted with Open Text (including 1 which doesn't sit too well with us) .

If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive returns on equity.

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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.