Today we’ll look at Ørsted A/S (CPH:ORSTED) and reflect on its potential as an investment. 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. Second, we’ll look at its ROCE compared to similar companies. And finally, we’ll look at how its current liabilities are impacting 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. In general, businesses with a higher ROCE are usually better quality. 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?
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 Ørsted:
0.068 = ø10b ÷ (ø186b – ø37b) (Based on the trailing twelve months to June 2019.)
Therefore, Ørsted has an ROCE of 6.8%.
Is Ørsted’s ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. We can see Ørsted’s ROCE is around the 7.3% average reported by the Electric Utilities industry. Setting aside the industry comparison for now, Ørsted’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.
In our analysis, Ørsted’s ROCE appears to be 6.8%, compared to 3 years ago, when its ROCE was 4.7%. This makes us think the business might be improving.
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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Ørsted.
Ørsted’s Current Liabilities And Their Impact On 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 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Ørsted has total assets of ø186b and current liabilities of ø37b. As a result, its current liabilities are equal to approximately 20% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.
Our Take On Ørsted’s ROCE
If Ørsted continues to earn an uninspiring ROCE, there may be better places to invest. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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 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. Thank you for reading.