Today we’ll look at Sophos Group plc (LON:SOPH) 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 up, we’ll look at what ROCE is and how we calculate it. 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.
What is 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. All else being equal, a better business will have a higher ROCE. Ultimately, it is a useful but imperfect metric. 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 Sophos Group:
0.07 = US$56m ÷ (US$1.4b – US$572m) (Based on the trailing twelve months to March 2019.)
Therefore, Sophos Group has an ROCE of 7.0%.
Is Sophos Group’s ROCE Good?
One way to assess ROCE is to compare similar companies. Using our data, Sophos Group’s ROCE appears to be significantly below the 8.9% average in the Software industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Aside from the industry comparison, Sophos Group’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, Sophos Group’s ROCE appears to be 7.0%, compared to 3 years ago, when its ROCE was 1.3%. This makes us wonder if the company is improving. You can see in the image below how Sophos Group’s ROCE compares to its industry.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Sophos Group’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.
Sophos Group has total liabilities of US$572m and total assets of US$1.4b. Therefore its current liabilities are equivalent to approximately 42% of its total assets. Sophos Group’s middling level of current liabilities have the effect of boosting its ROCE a bit.
The Bottom Line On Sophos Group’s ROCE
Despite this, its ROCE is still mediocre, and you may find more appealing investments elsewhere. You might be able to find a better investment than Sophos Group. 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).
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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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.