Today we are going to look at Canadian Pacific Railway Limited (TSE:CP) to see whether it might be an attractive investment prospect. Specifically, we’ll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.
First of all, we’ll work out how to calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. And finally, we’ll look at how its current liabilities are impacting its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. All else being equal, a better business will have a higher ROCE. Overall, it is a valuable metric that has its flaws. 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?
Analysts use this formula to calculate return on capital employed:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
Or for Canadian Pacific Railway:
0.17 = CA$3.5b ÷ (CA$22b – CA$2.3b) (Based on the trailing twelve months to December 2019.)
So, Canadian Pacific Railway has an ROCE of 17%.
Does Canadian Pacific Railway Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. In our analysis, Canadian Pacific Railway’s ROCE is meaningfully higher than the 11% average in the Transportation 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. Independently of how Canadian Pacific Railway compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
The image below shows how Canadian Pacific Railway’s ROCE compares to its industry, and you can click it to see more detail on its past growth.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. 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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Do Canadian Pacific Railway’s Current Liabilities Skew 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Canadian Pacific Railway has current liabilities of CA$2.3b and total assets of CA$22b. Therefore its current liabilities are equivalent to approximately 10% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
What We Can Learn From Canadian Pacific Railway’s ROCE
With that in mind, Canadian Pacific Railway’s ROCE appears pretty good. There might be better investments than Canadian Pacific Railway out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
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If you spot an error that warrants correction, please contact the editor at email@example.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.
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