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To find a multi-bagger stock, what are the underlying trends we should look for in a business? 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. Having said that, from a first glance at Digi International (NASDAQ:DGII) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.
Understanding 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 Digi International, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.027 = US$15m ÷ (US$608m - US$57m) (Based on the trailing twelve months to March 2021).
Therefore, Digi International has an ROCE of 2.7%. In absolute terms, that's a low return and it also under-performs the Communications industry average of 7.9%.
In the above chart we have measured Digi International'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 Digi International here for free.
What The Trend Of ROCE Can Tell Us
On the surface, the trend of ROCE at Digi International doesn't inspire confidence. Over the last five years, returns on capital have decreased to 2.7% from 5.6% 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. If these investments prove successful, this can bode very well for long term stock performance.
The Key Takeaway
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Digi International. Furthermore the stock has climbed 83% over the last five years, it would appear that investors are upbeat about the future. So while the underlying trends could already be accounted for by investors, we still think this stock is worth looking into further.
On a final note, we've found 2 warning signs for Digi International that we think you should be aware of.
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.
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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