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If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. 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. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. Although, when we looked at PagSeguro Digital (NYSE:PAGS), it didn't seem to tick all of these boxes.
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. Analysts use this formula to calculate it for PagSeguro Digital:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.15 = R$1.7b ÷ (R$22b - R$11b) (Based on the trailing twelve months to March 2021).
Therefore, PagSeguro Digital has an ROCE of 15%. On its own, that's a standard return, however it's much better than the 11% generated by the IT industry.
In the above chart we have measured PagSeguro Digital'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 PagSeguro Digital here for free.
The Trend Of ROCE
In terms of PagSeguro Digital's historical ROCE movements, the trend isn't fantastic. Around five years ago the returns on capital were 19%, but since then they've fallen to 15%. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.
On a side note, PagSeguro Digital has done well to pay down its current liabilities to 49% of total assets. So we could link some of this to the decrease in ROCE. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE. Keep in mind 49% is still pretty high, so those risks are still somewhat prevalent.
While returns have fallen for PagSeguro Digital in recent times, we're encouraged to see that sales are growing and that the business is reinvesting in its operations. And the stock has done incredibly well with a 103% return over the last three years, so long term investors are no doubt ecstatic with that result. So should these growth trends continue, we'd be optimistic on the stock going forward.
PagSeguro Digital does have some risks, we noticed 3 warning signs (and 1 which is significant) we think you should know about.
If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive 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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