Today we’ll look at Watsco, Inc. (NYSE:WSO) and reflect on its potential as an investment. Specifically, we’ll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.
First, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. Finally, we’ll look at how its current liabilities affect its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE measures the ‘return’ (pre-tax profit) a company generates from capital employed in its business. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. 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?
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 Watsco:
0.18 = US$361m ÷ (US$2.6b – US$581m) (Based on the trailing twelve months to June 2019.)
So, Watsco has an ROCE of 18%.
Is Watsco’s ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. Watsco’s ROCE appears to be substantially greater than the 9.0% average in the Trade Distributors industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Independently of how Watsco compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during 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 Watsco.
Do Watsco’s Current Liabilities Skew 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Watsco has total liabilities of US$581m and total assets of US$2.6b. Therefore its current liabilities are equivalent to approximately 22% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.
The Bottom Line On Watsco’s ROCE
Overall, Watsco has a decent ROCE and could be worthy of further research. There might be better investments than Watsco out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
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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.