There are a few key trends to look for if we want to identify the next multi-bagger. Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base 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 Guangdong Topstar Technology (SZSE:300607), 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 Guangdong Topstar Technology is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.035 = CN¥120m ÷ (CN¥6.8b - CN¥3.4b) (Based on the trailing twelve months to June 2024).
Thus, Guangdong Topstar Technology has an ROCE of 3.5%. Ultimately, that's a low return and it under-performs the Machinery industry average of 5.8%.
In the above chart we have measured Guangdong Topstar Technology's prior ROCE against its prior performance, but the future is arguably more important. If you'd like to see what analysts are forecasting going forward, you should check out our free analyst report for Guangdong Topstar Technology .
So How Is Guangdong Topstar Technology's ROCE Trending?
In terms of Guangdong Topstar Technology's historical ROCE movements, the trend isn't fantastic. Over the last five years, returns on capital have decreased to 3.5% from 19% 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 49%, which has impacted the ROCE. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. What this means is that in reality, a rather large portion of the business is being funded by the likes of the company's suppliers or short-term creditors, which can bring some risks of its own.
In Conclusion...
In summary, we're somewhat concerned by Guangdong Topstar Technology's diminishing returns on increasing amounts of capital. Investors haven't taken kindly to these developments, since the stock has declined 23% from where it was five years ago. That being the case, unless the underlying trends revert to a more positive trajectory, we'd consider looking elsewhere.
One more thing to note, we've identified 2 warning signs with Guangdong Topstar Technology and understanding them should be part of your investment process.
If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive 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.