Should You Worry About Freehold Royalties Ltd.’s (TSE:FRU) ROCE?

Today we are going to look at Freehold Royalties Ltd. (TSE:FRU) to see whether it might be an attractive investment prospect. 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.

Firstly, we’ll go over how we calculate ROCE. Next, we’ll compare it to others in its industry. Last but not least, we’ll look at what impact its current liabilities have on 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. Generally speaking a higher ROCE is better. Ultimately, it is a useful but imperfect metric. 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:

0.025 = CA$21m ÷ (CA$864m – CA$14m) (Based on the trailing twelve months to March 2019.)

Therefore, Freehold Royalties has an ROCE of 2.5%.

View our latest analysis for Freehold Royalties

Is Freehold Royalties’s ROCE Good?

One way to assess ROCE is to compare similar companies. Using our data, Freehold Royalties’s ROCE appears to be significantly below the 6.3% average in the Oil and Gas industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Independently of how Freehold Royalties compares to its industry, its ROCE in absolute terms is low; especially compared to the ~1.9% available in government bonds. Readers may wish to look for more rewarding investments.

Freehold Royalties reported an ROCE of 2.5% — better than 3 years ago, when the company didn’t make a profit. That implies the business has been improving.

TSX:FRU Past Revenue and Net Income, August 2nd 2019
TSX:FRU Past Revenue and Net Income, August 2nd 2019

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. 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

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.

Freehold Royalties has total liabilities of CA$14m and total assets of CA$864m. As a result, its current liabilities are equal to approximately 1.6% of its total assets. With barely any current liabilities, there is minimal impact on Freehold Royalties’s admittedly low ROCE.

What We Can Learn From Freehold Royalties’s ROCE

Nevertheless, there are potentially more attractive companies to invest in. Of course, you might also be able to find a better stock than Freehold Royalties. So you may wish to see this free collection of other companies that have grown earnings strongly.

If you like to buy stocks alongside management, then you might just love this free list 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.