Today we’ll evaluate The L.S. Starrett Company (NYSE:SCX) to determine whether it could have potential as an investment idea. 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.
Firstly, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. Then we’ll determine how its current liabilities are affecting 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. In general, businesses with a higher ROCE are usually better quality. 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 L.S. Starrett:
0.065 = US$10m ÷ (US$191m – US$31m) (Based on the trailing twelve months to December 2019.)
Therefore, L.S. Starrett has an ROCE of 6.5%.
Is L.S. Starrett’s ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. We can see L.S. Starrett’s ROCE is meaningfully below the Machinery industry average of 11%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Aside from the industry comparison, L.S. Starrett’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.
L.S. Starrett has an ROCE of 6.5%, but it didn’t have an ROCE 3 years ago, since it was unprofitable. This makes us wonder if the company is improving. You can click on the image below to see (in greater detail) how L.S. Starrett’s past growth compares to other companies.
When considering ROCE, bear in mind that it reflects the past and does not necessarily 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. You can check if L.S. Starrett has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
How L.S. Starrett’s Current Liabilities Impact 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.
L.S. Starrett has total assets of US$191m and current liabilities of US$31m. Therefore its current liabilities are equivalent to approximately 16% of its total assets. It is good to see a restrained amount of current liabilities, as this limits the effect on ROCE.
Our Take On L.S. Starrett’s ROCE
If L.S. Starrett continues to earn an uninspiring ROCE, there may be better places to invest. You might be able to find a better investment than L.S. Starrett. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
L.S. Starrett is not the only stock that insiders are buying. For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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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