What are the early trends we should look for to identify a stock that could multiply in value over the long term? 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. However, after briefly looking over the numbers, we don't think SolarWinds (NYSE:SWI) has the makings of a multi-bagger going forward, but let's have a look at why that may be.
Return On Capital Employed (ROCE): What is it?
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 SolarWinds, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.028 = US$140m ÷ (US$5.4b - US$445m) (Based on the trailing twelve months to September 2020).
Thus, SolarWinds has an ROCE of 2.8%. Ultimately, that's a low return and it under-performs the Software industry average of 9.6%.
Check out our latest analysis for SolarWinds
In the above chart we have measured SolarWinds' 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.
So How Is SolarWinds' ROCE Trending?
When we looked at the ROCE trend at SolarWinds, we didn't gain much confidence. To be more specific, ROCE has fallen from 23% over the last five years. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. If these investments prove successful, this can bode very well for long term stock performance.
On a related note, SolarWinds has decreased its current liabilities to 8.2% of total assets. So we could link some of this to the decrease in ROCE. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.The Key Takeaway
In summary, despite lower returns in the short term, we're encouraged to see that SolarWinds is reinvesting for growth and has higher sales as a result. However, despite the promising trends, the stock has fallen 22% over the last year, so there might be an opportunity here for astute investors. As a result, we'd recommend researching this stock further to uncover what other fundamentals of the business can show us.
SolarWinds does come with some risks though, we found 4 warning signs in our investment analysis, and 1 of those can't be ignored...
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
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This article by Simply Wall St is general in nature. 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.
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About NYSE:SWI
SolarWinds
Provides information technology (IT) management software products in the United States and internationally.
Moderate growth potential with acceptable track record.
