Why You Should Care About Toll Brothers, Inc.’s (NYSE:TOL) Low Return On Capital

Today we'll look at Toll Brothers, Inc. (NYSE:TOL) 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 of all, we'll work out how to calculate ROCE. Next, we'll compare it to others in its industry. 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 is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Generally speaking a higher ROCE is better. 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 Toll Brothers:

0.07 = US$639m ÷ (US$11b - US$1.4b) (Based on the trailing twelve months to January 2020.)

So, Toll Brothers has an ROCE of 7.0%.

Check out our latest analysis for Toll Brothers

Is Toll Brothers's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. In this analysis, Toll Brothers's ROCE appears meaningfully below the 12% average reported by the Consumer Durables industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Aside from the industry comparison, Toll Brothers'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, Toll Brothers's ROCE appears to be 7.0%, compared to 3 years ago, when its ROCE was 5.6%. This makes us wonder if the company is improving. The image below shows how Toll Brothers's ROCE compares to its industry, and you can click it to see more detail on its past growth.

It is important to remember that ROCE shows past performance, and is 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. 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 Toll Brothers.

What Are Current Liabilities, And How Do They Affect Toll Brothers's ROCE?

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counter this, investors can check if a company has high current liabilities relative to total assets.

Toll Brothers has total assets of US$11b and current liabilities of US$1.4b. Therefore its current liabilities are equivalent to approximately 13% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.

What We Can Learn From Toll Brothers's ROCE

If Toll Brothers continues to earn an uninspiring ROCE, there may be better places to invest. You might be able to find a better investment than Toll Brothers. 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).

Toll Brothers is not the only stock insiders are buying. So take a peek at this free list of growing companies with insider buying.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

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. Thank you for reading.