Are First Derivatives plc’s (LON:FDP) High Returns Really That Great?

Today we'll look at First Derivatives plc (LON:FDP) and reflect on its potential as an investment. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. All else being equal, a better business will have a higher ROCE. In brief, it is a useful tool, but it is not without drawbacks. Renowned investment researcher Michael Mauboussin has suggested that a high ROCE can indicate that 'one dollar invested in the company generates value of more than one dollar'.

How Do You Calculate Return On Capital Employed?

The formula for calculating the return on capital employed is:

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

Or for First Derivatives:

0.14 = UK£23m ÷ (UK£278m - UK£121m) (Based on the trailing twelve months to February 2019.)

Therefore, First Derivatives has an ROCE of 14%.

Check out our latest analysis for First Derivatives

Is First Derivatives's ROCE Good?

One way to assess ROCE is to compare similar companies. In our analysis, First Derivatives's ROCE is meaningfully higher than the 11% average in the Software industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Separate from First Derivatives's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

Our data shows that First Derivatives currently has an ROCE of 14%, compared to its ROCE of 6.4% 3 years ago. This makes us think the business might be improving.

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is only a point-in-time measure. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for First Derivatives.

How First Derivatives's Current Liabilities Impact Its ROCE

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counter this, investors can check if a company has high current liabilities relative to total assets.

First Derivatives has total liabilities of UK£121m and total assets of UK£278m. Therefore its current liabilities are equivalent to approximately 43% of its total assets. With this level of current liabilities, First Derivatives's ROCE is boosted somewhat.

Our Take On First Derivatives's ROCE

First Derivatives's ROCE does look good, but the level of current liabilities also contribute to that. First Derivatives looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.

I will like First Derivatives better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.