There are a few key trends to look for if we want to identify the next multi-bagger. 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. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. So when we looked at Smartgroup (ASX:SIQ), they do have a high ROCE, but we weren't exactly elated from how returns are trending.

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Return On Capital Employed (ROCE): What Is It?

Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Analysts use this formula to calculate it for Smartgroup:

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

0.32 = AU$108m ÷ (AU$653m - AU$313m) (Based on the trailing twelve months to December 2024).

Thus, Smartgroup has an ROCE of 32%. In absolute terms that's a great return and it's even better than the Professional Services industry average of 16%.

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'd like to see what analysts are forecasting going forward, you should check out our free analyst report for Smartgroup .

What Does the ROCE Trend For Smartgroup Tell Us?

Over the past five years, Smartgroup's ROCE and capital employed have both remained mostly flat. Businesses with these traits tend to be mature and steady operations because they're past the growth phase. So it may not be a multi-bagger in the making, but given the decent 32% return on capital, it'd be difficult to find fault with the business's current operations. That probably explains why Smartgroup has been paying out 77% of its earnings as dividends to shareholders. These mature businesses typically have reliable earnings and not many places to reinvest them, so the next best option is to put the earnings into shareholders pockets.

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 48% of total assets, this reported ROCE would probably be less than32% because total capital employed would be higher.The 32% ROCE could be even lower if current liabilities weren't 48% 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 Bottom Line On Smartgroup's ROCE

In summary, Smartgroup isn't compounding its earnings but is generating decent returns on the same amount of capital employed. Investors must think there's better things to come because the stock has knocked it out of the park, delivering a 102% gain to shareholders who have held over the last five years. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.

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

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.