Today we are going to look at Champion Iron Limited (ASX:CIA) to see whether it might be an attractive investment prospect. 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. Finally, we’ll look at how its current liabilities affect its ROCE.
Understanding 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. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.
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 Champion Iron:
0.53 = CA$357m ÷ (CA$798m – CA$125m) (Based on the trailing twelve months to December 2019.)
So, Champion Iron has an ROCE of 53%.
Does Champion Iron Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. Champion Iron’s ROCE appears to be substantially greater than the 9.7% average in the Metals and Mining 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. Regardless of the industry comparison, in absolute terms, Champion Iron’s ROCE currently appears to be excellent.
Champion Iron has an ROCE of 53%, but it didn’t have an ROCE 3 years ago, since it was unprofitable. That implies the business has been improving. You can see in the image below how Champion Iron’s ROCE compares to its industry. Click to see more on past growth.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Remember that most companies like Champion Iron are cyclical businesses. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Champion Iron.
What Are Current Liabilities, And How Do They Affect Champion Iron’s ROCE?
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Champion Iron has total assets of CA$798m and current liabilities of CA$125m. Therefore its current liabilities are equivalent to approximately 16% of its total assets. The fairly low level of current liabilities won’t have much impact on the already great ROCE.
What We Can Learn From Champion Iron’s ROCE
This is good to see, and with such a high ROCE, Champion Iron may be worth a closer look. Champion Iron 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.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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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