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Today we’ll evaluate Spirit Telecom Limited (ASX:ST1) to determine whether it could have potential as an investment idea. 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. Second, we’ll look at its ROCE compared 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 is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the business. Generally speaking a higher ROCE is better. 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?
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 Spirit Telecom:
0.085 = AU$1.6m ÷ (AU$22m – AU$2.8m) (Based on the trailing twelve months to June 2018.)
Therefore, Spirit Telecom has an ROCE of 8.5%.
Check out our latest analysis for Spirit Telecom
Does Spirit Telecom Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. We can see Spirit Telecom’s ROCE is around the 9.8% average reported by the Telecom industry. Separate from how Spirit Telecom stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Investors may wish to consider higher-performing investments.
Spirit Telecom has an ROCE of 8.5%, but it didn’t have an ROCE 3 years ago, since it was unprofitable. That suggests the business has returned to profitability.
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. Since the future is so important for investors, you should check out our free report on analyst forecasts for Spirit Telecom.
Do Spirit Telecom’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 counter this, investors can check if a company has high current liabilities relative to total assets.
Spirit Telecom has total liabilities of AU$2.8m and total assets of AU$22m. As a result, its current liabilities are equal to approximately 13% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.
What We Can Learn From Spirit Telecom’s ROCE
If Spirit Telecom continues to earn an uninspiring ROCE, there may be better places to invest. You might be able to find a better buy than Spirit Telecom. If you want a selection of possible winners, check out this free list 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 free list of growing companies with recent insider purchasing, could be just the ticket.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.