Today we’ll look at Aurizon Holdings Limited (ASX:AZJ) and reflect on its potential as an investment. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First, we’ll go over how we calculate ROCE. Next, we’ll compare it to others in its industry. And finally, we’ll look at how its current liabilities are impacting 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. In general, businesses with a higher ROCE are usually better quality. 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?
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 Aurizon Holdings:
0.10 = AU$878m ÷ (AU$9.7b – AU$949m) (Based on the trailing twelve months to June 2019.)
So, Aurizon Holdings has an ROCE of 10%.
Is Aurizon Holdings’s ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. It appears that Aurizon Holdings’s ROCE is fairly close to the Transportation industry average of 11%. Aside from the industry comparison, Aurizon Holdings’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.
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, after all, simply a snap shot of a single year. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Aurizon Holdings.
How Aurizon 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Aurizon Holdings has total liabilities of AU$949m and total assets of AU$9.7b. As a result, its current liabilities are equal to approximately 9.8% of its total assets. With low levels of current liabilities, at least Aurizon Holdings’s mediocre ROCE is not unduly boosted.
What We Can Learn From Aurizon Holdings’s ROCE
If performance improves, then Aurizon Holdings may be an OK investment, especially at the right valuation. Of course, you might also be able to find a better stock than Aurizon Holdings. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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. Thank you for reading.