If you're not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out for. Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. Having said that, while the ROCE is currently high for Smartgroup (ASX:SIQ), we aren't jumping out of our chairs because returns are decreasing.

What Is Return On Capital Employed (ROCE)?

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. To calculate this metric for Smartgroup, this is the formula:

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

0.31 = AU$99m ÷ (AU$543m - AU$220m) (Based on the trailing twelve months to June 2024).

So, Smartgroup has an ROCE of 31%. In absolute terms that's a great return and it's even better than the Professional Services industry average of 19%.

Check out our latest analysis for Smartgroup

In the above chart we have measured Smartgroup's prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free analyst report for Smartgroup .

So How Is Smartgroup's ROCE Trending?

Things have been pretty stable at Smartgroup, with its capital employed and returns on that capital staying somewhat the same for the last five years. Businesses with these traits tend to be mature and steady operations because they're past the growth phase. Although current returns are high, we'd need more evidence of underlying growth for it to look like a multi-bagger going forward. That being the case, it makes sense that Smartgroup has been paying out 82% of its earnings to its shareholders. If the company is in fact lacking growth opportunities, that's one of the viable alternatives for the money.

Another point to note, we noticed the company has increased current liabilities over the last five years. This is intriguing because if current liabilities hadn't increased to 41% of total assets, this reported ROCE would probably be less than31% because total capital employed would be higher.The 31% ROCE could be even lower if current liabilities weren't 41% of total assets, because the the formula would show a larger base of total capital employed. So with current liabilities at such high levels, this effectively means the likes of suppliers or short-term creditors are funding a meaningful part of the business, which in some instances can bring some risks.

The Key Takeaway

In summary, Smartgroup isn't compounding its earnings but is generating decent returns on the same amount of capital employed. Unsurprisingly then, the total return to shareholders over the last five years has been flat. In any case, the stock doesn't have these traits of a multi-bagger discussed above, so if that's what you're looking for, we think you'd have more luck elsewhere.

One more thing to note, we've identified 1 warning sign with Smartgroup and understanding this should be part of your investment process.

Smartgroup is not the only stock earning high returns. If you'd like to see more, check out our free list of companies earning high returns on equity with solid fundamentals.

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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.