Today we’ll look at A. O. Smith Corporation (NYSE:AOS) 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. Second, we’ll look at its ROCE compared to similar companies. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. In brief, it is a useful tool, but it is not without drawbacks. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.
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 A. O. Smith:
0.22 = US$511m ÷ (US$3.1b – US$730m) (Based on the trailing twelve months to September 2019.)
So, A. O. Smith has an ROCE of 22%.
Does A. O. Smith Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. A. O. Smith’s ROCE appears to be substantially greater than the 13% average in the Building industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Setting aside the comparison to its industry for a moment, A. O. Smith’s ROCE in absolute terms currently looks quite high.
You can see in the image below how A. O. Smith’s ROCE compares to its industry. Click to see more on past growth.
Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately 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 A. O. Smith.
How A. O. Smith’s Current Liabilities Impact Its ROCE
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counteract this, we check if a company has high current liabilities, relative to its total assets.
A. O. Smith has total liabilities of US$730m and total assets of US$3.1b. Therefore its current liabilities are equivalent to approximately 24% of its total assets. The fairly low level of current liabilities won’t have much impact on the already great ROCE.
Our Take On A. O. Smith’s ROCE
Low current liabilities and high ROCE is a good combination, making A. O. Smith look quite interesting. A. O. Smith shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
I will like A. O. Smith 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 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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