Should You Like carsales.com Ltd’s (ASX:CAR) High Return On Capital Employed?

Today we'll evaluate carsales.com Ltd (ASX:CAR) to determine whether it could have potential as an investment idea. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE 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 metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. 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'.

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 carsales.com:

0.22 = AU$188m ÷ (AU$926m - AU$65m) (Based on the trailing twelve months to December 2018.)

So, carsales.com has an ROCE of 22%.

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Is carsales.com's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. In our analysis, carsales.com's ROCE is meaningfully higher than the 12% average in the Interactive Media and Services industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Setting aside the comparison to its industry for a moment, carsales.com's ROCE in absolute terms currently looks quite high.

As we can see, carsales.com currently has an ROCE of 22%, less than the 34% it reported 3 years ago. Therefore we wonder if the company is facing new headwinds.

It is important to remember that ROCE shows past performance, and is 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, after all, simply a snap shot of a single year. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

What Are Current Liabilities, And How Do They Affect carsales.com's ROCE?

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counter this, investors can check if a company has high current liabilities relative to total assets.

carsales.com has total liabilities of AU$65m and total assets of AU$926m. Therefore its current liabilities are equivalent to approximately 7.0% of its total assets. Modest current liabilities are not boosting carsales.com's very nice ROCE.

The Bottom Line On carsales.com's ROCE

This is an attractive combination and suggests the company could have potential. carsales.com shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.

If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.

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.