Today we’ll look at Cochlear Limited (ASX:COH) 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 up, we’ll look at what ROCE is and how we calculate it. Then we’ll compare its ROCE to similar companies. Last but not least, we’ll look at what impact its current liabilities have on 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. All else being equal, a better business will have a higher ROCE. 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’.
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 Cochlear:
0.28 = AU$357m ÷ (AU$1.6b – AU$350m) (Based on the trailing twelve months to December 2019.)
So, Cochlear has an ROCE of 28%.
Is Cochlear’s ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. In our analysis, Cochlear’s ROCE is meaningfully higher than the 11% average in the Medical Equipment industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Putting aside its position relative to its industry for now, in absolute terms, Cochlear’s ROCE is currently very good.
Cochlear’s current ROCE of 28% is lower than its ROCE in the past, which was 39%, 3 years ago. This makes us wonder if the business is facing new challenges. You can click on the image below to see (in greater detail) how Cochlear’s past growth compares to other companies.
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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Do Cochlear’s Current Liabilities Skew Its ROCE?
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.
Cochlear has total assets of AU$1.6b and current liabilities of AU$350m. Therefore its current liabilities are equivalent to approximately 21% of its total assets. A minimal amount of current liabilities limits the impact on ROCE.
What We Can Learn From Cochlear’s ROCE
With low current liabilities and a high ROCE, Cochlear could be worthy of further investigation. Cochlear 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 are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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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