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Today we are going to look at Waterco Limited (ASX:WAT) to see whether it might be an attractive investment prospect. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First up, we’ll look at what ROCE is and how we calculate it. Next, we’ll compare it to others in its industry. Then we’ll determine how its current liabilities are affecting its ROCE.
Understanding 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. Overall, it is a valuable metric that has its flaws. 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 Waterco:
0.074 = AU$6.7m ÷ (AU$117m – AU$25m) (Based on the trailing twelve months to June 2018.)
So, Waterco has an ROCE of 7.4%.
Does Waterco Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. We can see Waterco’s ROCE is meaningfully below the Leisure industry average of 13%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Aside from the industry comparison, Waterco’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.
Waterco’s current ROCE of 7.4% is lower than its ROCE in the past, which was 14%, 3 years ago. Therefore we wonder if the company is facing new headwinds.
Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately predict the future. 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. You can check if Waterco has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Do Waterco’s Current Liabilities Skew Its ROCE?
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that 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.
Waterco has total liabilities of AU$25m and total assets of AU$117m. Therefore its current liabilities are equivalent to approximately 22% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.
Our Take On Waterco’s ROCE
If Waterco continues to earn an uninspiring ROCE, there may be better places to invest. You might be able to find a better buy than Waterco. 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).
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.