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. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. In light of that, when we looked at MeridianLink (NYSE:MLNK) 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. To calculate this metric for MeridianLink, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.015 = US$15m ÷ (US$1.0b - US$69m) (Based on the trailing twelve months to September 2023).
Thus, MeridianLink has an ROCE of 1.5%. In absolute terms, that's a low return and it also under-performs the Software industry average of 7.7%.
See our latest analysis for MeridianLink
Above you can see how the current ROCE for MeridianLink 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 MeridianLink doesn't inspire confidence. Over the last three years, returns on capital have decreased to 1.5% from 6.0% three years ago. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. 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.
What We Can Learn From MeridianLink's ROCE
Bringing it all together, while we're somewhat encouraged by MeridianLink's reinvestment in its own business, we're aware that returns are shrinking. Although the market must be expecting these trends to improve because the stock has gained 79% over the last year. But if the trajectory of these underlying trends continue, we think the likelihood of it being a multi-bagger from here isn't high.
While MeridianLink doesn't shine too bright in this respect, it's still worth seeing if the company is trading at attractive prices. You can find that out with our FREE intrinsic value estimation on our platform.
While MeridianLink 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.
