What trends should we look for it we want to identify stocks that can multiply in value over the long term? Amongst other things, we'll want to see two things; firstly, a growing return on capital employed (ROCE) and secondly, an expansion in the company's 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. Looking at Paychex (NASDAQ:PAYX), it does have a high ROCE right now, but lets see how returns are trending.
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 Paychex, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.34 = US$1.5b ÷ (US$9.2b - US$4.9b) (Based on the trailing twelve months to May 2021).
So, Paychex has an ROCE of 34%. In absolute terms that's a great return and it's even better than the IT industry average of 12%.
In the above chart we have measured Paychex'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 Paychex here for free.
What The Trend Of ROCE Can Tell Us
In terms of Paychex's historical ROCE movements, the trend isn't fantastic. Historically returns on capital were even higher at 55%, but they have dropped over the last five years. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.
On a related note, Paychex has decreased its current liabilities to 54% of total assets. So we could link some of this to the decrease in ROCE. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE. Keep in mind 54% is still pretty high, so those risks are still somewhat prevalent.
To conclude, we've found that Paychex is reinvesting in the business, but returns have been falling. Investors must think there's better things to come because the stock has knocked it out of the park, delivering a 124% gain to shareholders who have held over the last five years. But if the trajectory of these underlying trends continue, we think the likelihood of it being a multi-bagger from here isn't high.
Like most companies, Paychex does come with some risks, and we've found 1 warning sign that you should be aware of.
If you'd like to see other companies earning high returns, check out our free list of companies earning high returns with solid balance sheets here.
If you decide to trade Paychex, use the lowest-cost* platform that is rated #1 Overall by Barron’s, Interactive Brokers. Trade stocks, options, futures, forex, bonds and funds on 135 markets, all from a single integrated account. Promoted
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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.