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What are the early trends we should look for to identify a stock that could multiply in value over the long term? 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. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. With that in mind, we've noticed some promising trends at NEXTDC (ASX:NXT) so let's look a bit deeper.
Return On Capital Employed (ROCE): What is it?
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. Analysts use this formula to calculate it for NEXTDC:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.015 = AU$34m ÷ (AU$2.7b - AU$379m) (Based on the trailing twelve months to June 2020).
Therefore, NEXTDC has an ROCE of 1.5%. Ultimately, that's a low return and it under-performs the IT industry average of 9.9%.
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, you can check out the forecasts from the analysts covering NEXTDC here for free.
What Can We Tell From NEXTDC's ROCE Trend?
NEXTDC has recently broken into profitability so their prior investments seem to be paying off. The company was generating losses five years ago, but now it's earning 1.5% which is a sight for sore eyes. In addition to that, NEXTDC is employing 696% more capital than previously which is expected of a company that's trying to break into profitability. 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.
For the record though, there was a noticeable increase in the company's current liabilities over the period, so we would attribute some of the ROCE growth to that. Effectively this means that suppliers or short-term creditors are now funding 14% of the business, which is more than it was five years ago. It's worth keeping an eye on this because as the percentage of current liabilities to total assets increases, some aspects of risk also increase.
What We Can Learn From NEXTDC's ROCE
Overall, NEXTDC 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 496% 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.
Like most companies, NEXTDC does come with some risks, and we've found 1 warning sign that you should be aware of.
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.
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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