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. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. However, after investigating Gravity (NASDAQ:GRVY), we don't think it's current trends fit the mold of a multi-bagger.

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 Gravity:

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

0.18 = ?94b ÷ (?614b - ?97b) (Based on the trailing twelve months to June 2024).

So, Gravity has an ROCE of 18%. In absolute terms, that's a satisfactory return, but compared to the Entertainment industry average of 11% it's much better.

See our latest analysis for Gravity

Historical performance is a great place to start when researching a stock so above you can see the gauge for Gravity's ROCE against it's prior returns. If you want to delve into the historical earnings , check out these free graphs detailing revenue and cash flow performance of Gravity.

So How Is Gravity's ROCE Trending?

When we looked at the ROCE trend at Gravity, we didn't gain much confidence. Over the last five years, returns on capital have decreased to 18% from 52% five years ago. And considering revenue has dropped while employing more capital, we'd be cautious. This could mean that the business is losing its competitive advantage or market share, because while more money is being put into ventures, it's actually producing a lower return - "less bang for their buck" per se.

On a related note, Gravity has decreased its current liabilities to 16% of total assets. That could partly explain why the ROCE has dropped. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.

What We Can Learn From Gravity's ROCE

We're a bit apprehensive about Gravity because despite more capital being deployed in the business, returns on that capital and sales have both fallen. However the stock has delivered a 87% return to shareholders over the last five years, so investors might be expecting the trends to turn around. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.