Is G8 Education Limited’s (ASX:GEM) Capital Allocation Ability Worth Your Time?

Today we’ll look at G8 Education Limited (ASX:GEM) 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.

Firstly, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. And finally, we’ll look at how its current liabilities are impacting 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. 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?

The formula for calculating the return on capital employed is:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)

Or for G8 Education:

0.13 = AU$130m ÷ (AU$1.4b – AU$387m) (Based on the trailing twelve months to December 2018.)

Therefore, G8 Education has an ROCE of 13%.

See our latest analysis for G8 Education

Is G8 Education’s ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. It appears that G8 Education’s ROCE is fairly close to the Consumer Services industry average of 14%. Independently of how G8 Education compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

ASX:GEM Past Revenue and Net Income, April 25th 2019
ASX:GEM Past Revenue and Net Income, April 25th 2019

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 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.

How G8 Education’s Current Liabilities Impact 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 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.

G8 Education has total liabilities of AU$387m and total assets of AU$1.4b. As a result, its current liabilities are equal to approximately 28% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.

What We Can Learn From G8 Education’s ROCE

This is good to see, and with a sound ROCE, G8 Education could be worth a closer look. G8 Education 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.

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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.

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. Thank you for reading.