Today we’ll evaluate Hammond Manufacturing Company Limited (TSE:HMM.A) 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 up, we’ll look at what ROCE is and how we calculate it. Next, we’ll compare it to others in its industry. Finally, we’ll look at how its current liabilities affect 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. 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 Hammond Manufacturing:
0.11 = CA$7.8m ÷ (CA$111m – CA$42m) (Based on the trailing twelve months to September 2019.)
So, Hammond Manufacturing has an ROCE of 11%.
Does Hammond Manufacturing Have A Good ROCE?
One way to assess ROCE is to compare similar companies. We can see Hammond Manufacturing’s ROCE is around the 10% average reported by the Electrical industry. Separate from Hammond Manufacturing’s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
We can see that, Hammond Manufacturing currently has an ROCE of 11% compared to its ROCE 3 years ago, which was 6.7%. This makes us think about whether the company has been reinvesting shrewdly. The image below shows how Hammond Manufacturing’s ROCE compares to its industry, and you can click it to see more detail on its past growth.
When considering this metric, keep in mind that it is backwards looking, and 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. You can check if Hammond Manufacturing has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
What Are Current Liabilities, And How Do They Affect Hammond Manufacturing’s 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Hammond Manufacturing has total assets of CA$111m and current liabilities of CA$42m. Therefore its current liabilities are equivalent to approximately 38% of its total assets. With this level of current liabilities, Hammond Manufacturing’s ROCE is boosted somewhat.
The Bottom Line On Hammond Manufacturing’s ROCE
While its ROCE looks good, it’s worth remembering that the current liabilities are making the business look better. Hammond Manufacturing 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.
Hammond Manufacturing is not the only stock insiders are buying. So take a peek at this free list of growing companies with insider buying.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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