Capital Allocation Trends At NEXTDC (ASX:NXT) Aren't Ideal
Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base of capital employed. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. Having said that, from a first glance at NEXTDC (ASX:NXT) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.
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. The formula for this calculation on NEXTDC is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.013 = AU$50m ÷ (AU$3.8b - AU$92m) (Based on the trailing twelve months to June 2023).
So, NEXTDC has an ROCE of 1.3%. In absolute terms, that's a low return and it also under-performs the IT industry average of 15%.
View our latest analysis for NEXTDC
In the above chart we have measured NEXTDC's prior ROCE against its prior performance, but the future is arguably more important. If you'd like to see what analysts are forecasting going forward, you should check out our free report for NEXTDC.
The Trend Of ROCE
When we looked at the ROCE trend at NEXTDC, we didn't gain much confidence. To be more specific, ROCE has fallen from 2.3% 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. If these investments prove successful, this can bode very well for long term stock performance.
In Conclusion...
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for NEXTDC. And the stock has done incredibly well with a 112% return over the last five years, so long term investors are no doubt ecstatic with that result. So while investors seem to be recognizing these promising trends, we would look further into this stock to make sure the other metrics justify the positive view.
NEXTDC does have some risks, we noticed 3 warning signs (and 1 which is a bit unpleasant) we think you should know about.
While NEXTDC 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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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.
