Here’s why Freehold Royalties Ltd.’s (TSE:FRU) Returns On Capital Matters So Much

Today we are going to look at Freehold Royalties Ltd. (TSE:FRU) to see whether it might be an attractive investment prospect. 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. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.

Return On Capital Employed (ROCE): What is it?

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. All else being equal, a better business will have a higher ROCE. In brief, it is a useful tool, but it is not without drawbacks. 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 Freehold Royalties:

0.022 = CA$19m ÷ (CA$869m - CA$12m) (Based on the trailing twelve months to June 2019.)

So, Freehold Royalties has an ROCE of 2.2%.

Check out our latest analysis for Freehold Royalties

Does Freehold Royalties Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. We can see Freehold Royalties's ROCE is meaningfully below the Oil and Gas industry average of 5.1%. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Putting aside Freehold Royalties's performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. Readers may wish to look for more rewarding investments.

Freehold Royalties reported an ROCE of 2.2% -- better than 3 years ago, when the company didn't make a profit. That suggests the business has returned to profitability. The image below shows how Freehold Royalties's ROCE compares to its industry.

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. Remember that most companies like Freehold Royalties are cyclical businesses. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Freehold Royalties.

Freehold Royalties's Current Liabilities And Their Impact On 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 the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counter this, investors can check if a company has high current liabilities relative to total assets.

Freehold Royalties has total liabilities of CA$12m and total assets of CA$869m. As a result, its current liabilities are equal to approximately 1.3% of its total assets. Freehold Royalties has a low level of current liabilities, which have a negligible impact on its already low ROCE.

What We Can Learn From Freehold Royalties's ROCE

Nonetheless, there may be better places to invest your capital. But note: make sure you look for a great company, not just the first idea you come across. 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 Freehold Royalties 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.