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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? 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. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. However, after investigating Tucows (NASDAQ:TCX), we don't think it's current trends fit the mold of a multi-bagger.
Return On Capital Employed (ROCE): What is it?
If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. To calculate this metric for Tucows, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.075 = US$21m ÷ (US$445m - US$165m) (Based on the trailing twelve months to September 2020).
So, Tucows has an ROCE of 7.5%. In absolute terms, that's a low return and it also under-performs the IT industry average of 9.6%.
Historical performance is a great place to start when researching a stock so above you can see the gauge for Tucows' ROCE against it's prior returns. If you want to delve into the historical earnings, revenue and cash flow of Tucows, check out these free graphs here.
How Are Returns Trending?
In terms of Tucows' historical ROCE movements, the trend isn't fantastic. Around five years ago the returns on capital were 32%, but since then they've fallen to 7.5%. 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.
On a related note, Tucows has decreased its current liabilities to 37% 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.
What We Can Learn From Tucows' ROCE
To conclude, we've found that Tucows is reinvesting in the business, but returns have been falling. Investors must think there's better things to come because the stock has knocked it out of the park, delivering a 289% gain to shareholders who have held over the last five years. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.
If you want to continue researching Tucows, you might be interested to know about the 3 warning signs that our analysis has discovered.
While Tucows 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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