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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? Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, 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. Although, when we looked at American Software (NASDAQ:AMSW.A), it didn't seem to tick all of these boxes.
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. The formula for this calculation on American Software is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.049 = US$6.1m ÷ (US$169m - US$44m) (Based on the trailing twelve months to July 2020).
So, American Software has an ROCE of 4.9%. Ultimately, that's a low return and it under-performs the Software industry average of 9.4%.
In the above chart we have measured American Software's prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.
The Trend Of ROCE
On the surface, the trend of ROCE at American Software doesn't inspire confidence. To be more specific, ROCE has fallen from 12% over the last five years. Meanwhile, the business is utilizing more capital but this hasn't moved the needle much in terms of sales in the past 12 months, so this could reflect longer term investments. It may take some time before the company starts to see any change in earnings from these investments.
Our Take On American Software's ROCE
Bringing it all together, while we're somewhat encouraged by American Software's reinvestment in its own business, we're aware that returns are shrinking. Since the stock has gained an impressive 77% over the last five years, investors must think there's better things to come. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.
On a final note, we've found 2 warning signs for American Software that we think you should be aware of.
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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