Today we’ll evaluate ABB Ltd (VTX:ABBN) to determine whether it could have potential as an investment idea. To be precise, we’ll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
First, we’ll go over how we calculate ROCE. Then we’ll compare its ROCE to similar companies. Then we’ll determine how its current liabilities are affecting 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. 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?
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 ABB:
0.14 = US$3.3b ÷ (US$45b – US$19b) (Based on the trailing twelve months to September 2018.)
So, ABB has an ROCE of 14%.
Does ABB Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. We can see ABB’s ROCE is around the 12% average reported by the Electrical industry. Separate from ABB’s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is only a point-in-time measure. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for ABB.
How ABB’s Current Liabilities Impact 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.
ABB has total assets of US$45b and current liabilities of US$19b. Therefore its current liabilities are equivalent to approximately 42% of its total assets. ABB has a middling amount of current liabilities, increasing its ROCE somewhat.
Our Take On ABB’s ROCE
While its ROCE looks good, it’s worth remembering that the current liabilities are making the business look better. Of course you might be able to find a better stock than ABB. So you may wish to see this free collection of other companies that have grown earnings strongly.
I will like ABB better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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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. Thank you for reading.