Today we’ll evaluate Red Eléctrica Corporación, S.A. (BME:REE) to determine whether it could have potential as an investment idea. In particular, we’ll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its 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.
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. In brief, it is a useful tool, but it is not without drawbacks. 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 Red Eléctrica Corporación:
0.10 = €1.1b ÷ (€13b – €2.3b) (Based on the trailing twelve months to December 2019.)
So, Red Eléctrica Corporación has an ROCE of 10%.
Is Red Eléctrica Corporación’s ROCE Good?
One way to assess ROCE is to compare similar companies. Red Eléctrica Corporación’s ROCE appears to be substantially greater than the 7.1% average in the Electric Utilities 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. Independently of how Red Eléctrica Corporación compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
You can see in the image below how Red Eléctrica Corporación’s ROCE compares to its industry. Click to see more on past growth.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. 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 Red Eléctrica Corporación.
How Red Eléctrica Corporación’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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Red Eléctrica Corporación has current liabilities of €2.3b and total assets of €13b. As a result, its current liabilities are equal to approximately 18% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.
What We Can Learn From Red Eléctrica Corporación’s ROCE
This is good to see, and with a sound ROCE, Red Eléctrica Corporación could be worth a closer look. Red Eléctrica Corporación 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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