Why We Like REA Group Limited’s (ASX:REA) 41% Return On Capital Employed

Today we’ll evaluate REA Group Limited (ASX:REA) to determine whether it could have potential as an investment idea. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First of all, we’ll work out how to calculate ROCE. Next, we’ll compare it to others in its industry. And finally, we’ll look at how its current liabilities are impacting its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. In general, businesses with a higher ROCE are usually better quality. Ultimately, it is a useful but imperfect metric. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.’

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 REA Group:

0.41 = AU$462m ÷ (AU$1.5b – AU$389m) (Based on the trailing twelve months to December 2018.)

Therefore, REA Group has an ROCE of 41%.

Check out our latest analysis for REA Group

Is REA Group’s ROCE Good?

One way to assess ROCE is to compare similar companies. REA Group’s ROCE appears to be substantially greater than the 11% average in the Interactive Media and Services industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Putting aside its position relative to its industry for now, in absolute terms, REA Group’s ROCE is currently very good.

ASX:REA Past Revenue and Net Income, March 24th 2019
ASX:REA Past Revenue and Net Income, March 24th 2019

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 REA Group.

Do REA Group’s Current Liabilities Skew 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. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

REA Group has total assets of AU$1.5b and current liabilities of AU$389m. As a result, its current liabilities are equal to approximately 26% of its total assets. The fairly low level of current liabilities won’t have much impact on the already great ROCE.

The Bottom Line On REA Group’s ROCE

This is good to see, and with such a high ROCE, REA Group may be worth a closer look. But note: REA Group may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

I will like REA Group better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider 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.