Today we’ll look at Rentokil Initial plc (LON:RTO) 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.
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.
Understanding 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. All else being equal, a better business will have a higher ROCE. Ultimately, it is a useful but imperfect metric. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.
So, How Do We Calculate ROCE?
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 Rentokil Initial:
0.12 = UK£293m ÷ (UK£3.4b – UK£916m) (Based on the trailing twelve months to December 2019.)
Therefore, Rentokil Initial has an ROCE of 12%.
Is Rentokil Initial’s ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. We can see Rentokil Initial’s ROCE is around the 11% average reported by the Commercial Services industry. Independently of how Rentokil Initial 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 Rentokil Initial’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 deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. 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.
How Rentokil Initial’s Current Liabilities Impact Its ROCE
Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Rentokil Initial has current liabilities of UK£916m and total assets of UK£3.4b. Therefore its current liabilities are equivalent to approximately 27% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
What We Can Learn From Rentokil Initial’s ROCE
This is good to see, and with a sound ROCE, Rentokil Initial could be worth a closer look. Rentokil Initial 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.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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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