Returns On Capital Signal Tricky Times Ahead For Absolute Software (TSE:ABST)
There are a few key trends to look for if we want to identify the next multi-bagger. 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. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. However, after investigating Absolute Software (TSE:ABST), we don't think it's current trends fit the mold of a multi-bagger.
Return On Capital Employed (ROCE): What is it?
For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. The formula for this calculation on Absolute Software is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.14 = US$15m ÷ (US$214m - US$110m) (Based on the trailing twelve months to December 2020).
Therefore, Absolute Software has an ROCE of 14%. In absolute terms, that's a pretty normal return, and it's somewhat close to the Software industry average of 12%.
See our latest analysis for Absolute Software
Above you can see how the current ROCE for Absolute Software compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.
What The Trend Of ROCE Can Tell Us
On the surface, the trend of ROCE at Absolute Software doesn't inspire confidence. Over the last five years, returns on capital have decreased to 14% from 35% five years ago. 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's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.
On a related note, Absolute Software has decreased its current liabilities to 52% 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. 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. Either way, they're still at a pretty high level, so we'd like to see them fall further if possible.
The Bottom Line
In summary, Absolute Software is reinvesting funds back into the business for growth but unfortunately it looks like sales haven't increased much just yet. Yet to long term shareholders the stock has gifted them an incredible 227% return in the last five years, so the market appears to be rosy about its future. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.
Like most companies, Absolute Software does come with some risks, and we've found 2 warning signs that you should be aware of.
While Absolute Software 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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