If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding 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. So when we looked at Datadog (NASDAQ:DDOG) and its trend of ROCE, we really liked what we saw.
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. Analysts use this formula to calculate it for Datadog:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.0021 = US$4.1m ÷ (US$2.5b - US$602m) (Based on the trailing twelve months to March 2022).
Therefore, Datadog has an ROCE of 0.2%. Ultimately, that's a low return and it under-performs the Software industry average of 9.7%.
In the above chart we have measured Datadog's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Datadog here for free.
What Does the ROCE Trend For Datadog Tell Us?
The fact that Datadog is now generating some pre-tax profits from its prior investments is very encouraging. About four years ago the company was generating losses but things have turned around because it's now earning 0.2% on its capital. In addition to that, Datadog is employing 2,683% more capital than previously which is expected of a company that's trying to break into profitability. This can indicate that there's plenty of opportunities to invest capital internally and at ever higher rates, both common traits of a multi-bagger.
One more thing to note, Datadog has decreased current liabilities to 24% of total assets over this period, which effectively reduces the amount of funding from suppliers or short-term creditors. This tells us that Datadog has grown its returns without a reliance on increasing their current liabilities, which we're very happy with.
The Bottom Line
To the delight of most shareholders, Datadog has now broken into profitability. And since the stock has fallen 16% over the last year, there might be an opportunity here. With that in mind, we believe the promising trends warrant this stock for further investigation.
One more thing to note, we've identified 3 warning signs with Datadog and understanding them should be part of your investment process.
While Datadog isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.
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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.
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