Here’s why Newcrest Mining Limited’s (ASX:NCM) Returns On Capital Matters So Much

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Today we'll look at Newcrest Mining Limited (ASX:NCM) 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 up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. All else being equal, a better business will have a higher ROCE. 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 Newcrest Mining:

0.058 = US$468m ÷ (US$11b - US$637m) (Based on the trailing twelve months to December 2018.)

So, Newcrest Mining has an ROCE of 5.8%.

View our latest analysis for Newcrest Mining

Is Newcrest Mining's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. We can see Newcrest Mining's ROCE is meaningfully below the Metals and Mining industry average of 11%. 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, Newcrest Mining'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.

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. 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. Remember that most companies like Newcrest Mining are cyclical businesses. What happens in the future is pretty important for investors, so we have prepared a freereport on analyst forecasts for Newcrest Mining.

Newcrest Mining's Current Liabilities And Their Impact On Its 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 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.

Newcrest Mining has total assets of US$11b and current liabilities of US$637m. As a result, its current liabilities are equal to approximately 5.6% of its total assets. With low levels of current liabilities, at least Newcrest Mining's mediocre ROCE is not unduly boosted.

Our Take On Newcrest Mining's ROCE

Newcrest Mining looks like an ok business, but on this analysis it is not at the top of our buy list. You might be able to find a better buy than Newcrest Mining. If you want a selection of possible winners, check out this freelist 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 freelist of growing companies with recent insider purchasing, could be just the ticket.

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.