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. Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. However, after investigating Open Text (NASDAQ:OTEX), we don't think it's current trends fit the mold of a multi-bagger.
What Is Return On Capital Employed (ROCE)?
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 Open Text is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.054 = US$744m ÷ (US$17b - US$2.8b) (Based on the trailing twelve months to September 2023).
Therefore, Open Text has an ROCE of 5.4%. In absolute terms, that's a low return and it also under-performs the Software industry average of 7.7%.
Check out our latest analysis for Open Text
In the above chart we have measured Open Text'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 Open Text here for free.
So How Is Open Text's ROCE Trending?
On the surface, the trend of ROCE at Open Text doesn't inspire confidence. Around five years ago the returns on capital were 8.2%, but since then they've fallen to 5.4%. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.
In Conclusion...
In summary, despite lower returns in the short term, we're encouraged to see that Open Text is reinvesting for growth and has higher sales as a result. In light of this, the stock has only gained 31% over the last five years. So this stock may still be an appealing investment opportunity, if other fundamentals prove to be sound.
One more thing: We've identified 3 warning signs with Open Text (at least 1 which is concerning) , and understanding them would certainly be useful.
While Open Text 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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.