Today we are going to look at Graham Holdings Company (NYSE:GHC) 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.
First up, we’ll look at what ROCE is and how we calculate it. Next, we’ll compare it to others in its industry. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the business. Generally speaking a higher ROCE is better. 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 Graham Holdings:
0.065 = US$306m ÷ (US$5.6b – US$937m) (Based on the trailing twelve months to March 2020.)
So, Graham Holdings has an ROCE of 6.5%.
Is Graham Holdings’s ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. It appears that Graham Holdings’s ROCE is fairly close to the Consumer Services industry average of 7.6%. Separate from how Graham Holdings stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Readers may find more attractive investment prospects elsewhere.
You can see in the image below how Graham Holdings’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. ROCE is only a point-in-time measure. You can check if Graham Holdings has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
How Graham Holdings’s Current Liabilities Impact 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. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Graham Holdings has current liabilities of US$937m and total assets of US$5.6b. Therefore its current liabilities are equivalent to approximately 17% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.
Our Take On Graham Holdings’s ROCE
With that in mind, we’re not overly impressed with Graham Holdings’s ROCE, so it may not be the most appealing prospect. Of course, you might also be able to find a better stock than Graham Holdings. So you may wish to see this free collection of other companies that have grown earnings strongly.
There are plenty of other companies that have insiders buying up shares. You probably do not want to miss this free list of growing companies that insiders are buying.
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.