If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. In light of that, when we looked at DHC SoftwareLtd (SZSE:002065) and its ROCE trend, we weren't exactly thrilled.
Understanding 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 DHC SoftwareLtd is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.027 = CN¥324m ÷ (CN¥23b - CN¥11b) (Based on the trailing twelve months to September 2023).
Thus, DHC SoftwareLtd has an ROCE of 2.7%. Ultimately, that's a low return and it under-performs the IT industry average of 4.4%.
While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you'd like to look at how DHC SoftwareLtd has performed in the past in other metrics, you can view this free graph of DHC SoftwareLtd's past earnings, revenue and cash flow.
What Can We Tell From DHC SoftwareLtd's ROCE Trend?
On the surface, the trend of ROCE at DHC SoftwareLtd doesn't inspire confidence. To be more specific, ROCE has fallen from 11% 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'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.
Another thing to note, DHC SoftwareLtd has a high ratio of current liabilities to total assets of 47%. This can bring about some risks because the company is basically operating with a rather large reliance on its suppliers or other sorts of short-term creditors. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.
The Bottom Line
Bringing it all together, while we're somewhat encouraged by DHC SoftwareLtd's reinvestment in its own business, we're aware that returns are shrinking. Since the stock has declined 36% over the last five years, investors may not be too optimistic on this trend improving either. Therefore based on the analysis done in this article, we don't think DHC SoftwareLtd has the makings of a multi-bagger.
One more thing: We've identified 3 warning signs with DHC SoftwareLtd (at least 1 which can't be ignored) , and understanding them would certainly be useful.
While DHC SoftwareLtd isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.
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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.