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If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. In light of that, when we looked at Integrated Research (ASX:IRI) and its ROCE trend, we weren't exactly thrilled.
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 Integrated Research, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.058 = AU$6.2m ÷ (AU$135m - AU$29m) (Based on the trailing twelve months to December 2021).
Therefore, Integrated Research has an ROCE of 5.8%. Ultimately, that's a low return and it under-performs the Software industry average of 11%.
In the above chart we have measured Integrated Research'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 Integrated Research here for free.
What Does the ROCE Trend For Integrated Research Tell Us?
In terms of Integrated Research's historical ROCE movements, the trend isn't fantastic. Over the last five years, returns on capital have decreased to 5.8% from 38% five years ago. Given the business is employing more capital while revenue has slipped, this is a bit concerning. This could mean that the business is losing its competitive advantage or market share, because while more money is being put into ventures, it's actually producing a lower return - "less bang for their buck" per se.
On a side note, Integrated Research has done well to pay down its current liabilities to 22% 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 Bottom Line On Integrated Research's ROCE
In summary, we're somewhat concerned by Integrated Research's diminishing returns on increasing amounts of capital. This could explain why the stock has sunk a total of 87% in the last five years. With underlying trends that aren't great in these areas, we'd consider looking elsewhere.
If you'd like to know about the risks facing Integrated Research, we've discovered 3 warning signs that you should be aware of.
While Integrated Research may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.
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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.