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If you're not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out for. 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. Speaking of which, we noticed some great changes in Xero's (ASX:XRO) returns on capital, so let's have a look.
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. To calculate this metric for Xero, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.058 = NZ$141m ÷ (NZ$2.6b - NZ$229m) (Based on the trailing twelve months to September 2023).
Thus, Xero has an ROCE of 5.8%. In absolute terms, that's a low return and it also under-performs the Software industry average of 11%.
View our latest analysis for Xero
In the above chart we have measured Xero'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 Xero here for free.
What Can We Tell From Xero's ROCE Trend?
The fact that Xero is now generating some pre-tax profits from its prior investments is very encouraging. The company was generating losses five years ago, but now it's earning 5.8% which is a sight for sore eyes. And unsurprisingly, like most companies trying to break into the black, Xero is utilizing 189% more capital than it was five years ago. We like this trend, because it tells us the company has profitable reinvestment opportunities available to it, and if it continues going forward that can lead to a multi-bagger performance.
What We Can Learn From Xero's ROCE
Overall, Xero gets a big tick from us thanks in most part to the fact that it is now profitable and is reinvesting in its business. And a remarkable 159% total return over the last five years tells us that investors are expecting more good things to come in the future. So given the stock has proven it has promising trends, it's worth researching the company further to see if these trends are likely to persist.
On the other side of ROCE, we have to consider valuation. That's why we have a FREE intrinsic value estimation on our platform that is definitely worth checking out.