Are Technology One Limited’s (ASX:TNE) High Returns Really That Great?

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Today we'll evaluate Technology One Limited (ASX:TNE) to determine whether it could have potential as an investment idea. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

First up, we'll look at what ROCE is and how we calculate it. 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.

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. 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'.

How Do You Calculate Return On Capital Employed?

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 Technology One:

0.36 = AU$67m ÷ (AU$281m - AU$97m) (Based on the trailing twelve months to September 2018.)

So, Technology One has an ROCE of 36%.

See our latest analysis for Technology One

Does Technology One Have A Good ROCE?

One way to assess ROCE is to compare similar companies. Using our data, we find that Technology One's ROCE is meaningfully better than the 19% average in the Software industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of the industry comparison, in absolute terms, Technology One's ROCE currently appears to be excellent.

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 only a point-in-time measure. Future performance is what matters, and you can see analyst predictions in our freereport on analyst forecasts for the company.

Do Technology One'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. 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.

Technology One has total assets of AU$281m and current liabilities of AU$97m. As a result, its current liabilities are equal to approximately 35% of its total assets. Technology One has a medium level of current liabilities, boosting its ROCE somewhat.

What We Can Learn From Technology One's ROCE

Even so, it has a great ROCE, and could be an attractive prospect for further research. Technology One shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this freecollection of companies delivering excellent earnings growth.

If you like to buy stocks alongside management, then you might just love this freelist of companies. (Hint: insiders have been buying them).

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.