Don’t Buy Leonardo S.p.a. (BIT:LDO) Until You Understand Its ROCE

Today we are going to look at Leonardo S.p.a. (BIT:LDO) to see whether it might be an attractive investment prospect. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First of all, we'll work out how to calculate ROCE. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect 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. Ultimately, it is a useful but imperfect metric. 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 Leonardo:

0.094 = €1.1b ÷ (€18b - €6.7b) (Based on the trailing twelve months to September 2019.)

So, Leonardo has an ROCE of 9.4%.

Check out our latest analysis for Leonardo

Does Leonardo Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. We can see Leonardo's ROCE is around the 9.4% average reported by the Aerospace & Defense industry. Separate from Leonardo's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

We can see that, Leonardo currently has an ROCE of 9.4% compared to its ROCE 3 years ago, which was 7.0%. This makes us wonder if the company is improving. The image below shows how Leonardo's ROCE compares to its industry, and you can click it to see more detail on its past growth.

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 Leonardo.

Do Leonardo's Current Liabilities Skew Its ROCE?

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that need to be paid within 12 months. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Leonardo has total liabilities of €6.7b and total assets of €18b. As a result, its current liabilities are equal to approximately 37% of its total assets. Leonardo has a middling amount of current liabilities, increasing its ROCE somewhat.

Our Take On Leonardo's ROCE

Leonardo's ROCE does look good, but the level of current liabilities also contribute to that. There might be better investments than Leonardo 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.

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

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.

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