To find a multi-bagger stock, what are the underlying trends we should look for in a business? 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 Leader Harmonious Drive Systems (SHSE:688017), we don't think it's current trends fit the mold of a multi-bagger.

Understanding Return On Capital Employed (ROCE)

For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. The formula for this calculation on Leader Harmonious Drive Systems is:

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

0.017 = CN¥38m ÷ (CN¥2.8b - CN¥603m) (Based on the trailing twelve months to September 2023).

So, Leader Harmonious Drive Systems has an ROCE of 1.7%. Ultimately, that's a low return and it under-performs the Machinery industry average of 6.1%.

Above you can see how the current ROCE for Leader Harmonious Drive Systems 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 analyst report for Leader Harmonious Drive Systems .

The Trend Of ROCE

On the surface, the trend of ROCE at Leader Harmonious Drive Systems doesn't inspire confidence. Over the last five years, returns on capital have decreased to 1.7% 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.

While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 22%, which has impacted the ROCE. Without this increase, it's likely that ROCE would be even lower than 1.7%. While the ratio isn't currently too high, it's worth keeping an eye on this because if it gets particularly high, the business could then face some new elements of risk.

The Bottom Line

In summary, we're somewhat concerned by Leader Harmonious Drive Systems' diminishing returns on increasing amounts of capital. Yet despite these concerning fundamentals, the stock has performed strongly with a 68% return over the last three years, so investors appear very optimistic. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.

Like most companies, Leader Harmonious Drive Systems does come with some risks, and we've found 1 warning sign that you should be aware of.

For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.

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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.