Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. 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. However, after briefly looking over the numbers, we don't think SG Micro (SZSE:300661) has the makings of a multi-bagger going forward, but let's have a look at why that may be.

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. To calculate this metric for SG Micro, this is the formula:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.039 = CN¥154m ÷ (CN¥4.5b - CN¥536m) (Based on the trailing twelve months to September 2023).

Thus, SG Micro has an ROCE of 3.9%. On its own that's a low return on capital but it's in line with the industry's average returns of 4.2%.

Check out our latest analysis for SG Micro

In the above chart we have measured SG Micro'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 SG Micro here for free.

What The Trend Of ROCE Can Tell Us

When we looked at the ROCE trend at SG Micro, we didn't gain much confidence. Over the last five years, returns on capital have decreased to 3.9% from 11% five years ago. And considering revenue has dropped while employing more capital, we'd be cautious. If this were to continue, you might be looking at a company that is trying to reinvest for growth but is actually losing market share since sales haven't increased.

In Conclusion...

In summary, we're somewhat concerned by SG Micro's diminishing returns on increasing amounts of capital. Since the stock has skyrocketed 548% over the last five years, it looks like investors have high expectations of the stock. In any case, the current underlying trends don't bode well for long term performance so unless they reverse, we'd start looking elsewhere.

SG Micro does have some risks, we noticed 2 warning signs (and 1 which is potentially serious) we think you should know about.

While SG Micro may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.