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Today we’ll look at Software Aktiengesellschaft (ETR:SOW) and reflect on its potential as an investment. In particular, we’ll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.
First, we’ll go over how we calculate ROCE. Next, we’ll compare it to others in its industry. Then we’ll determine how its current liabilities are affecting its ROCE.
What is 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. All else being equal, a better business will have a higher ROCE. 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?
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 Software:
0.15 = €221m ÷ (€2.0b – €488m) (Based on the trailing twelve months to December 2018.)
Therefore, Software has an ROCE of 15%.
Is Software’s ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that Software’s ROCE is meaningfully better than the 8.2% average in the Software industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Separate from Software’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. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Software.
How Software’s Current Liabilities Impact Its ROCE
Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Software has total liabilities of €488m and total assets of €2.0b. Therefore its current liabilities are equivalent to approximately 24% of its total assets. Low current liabilities are not boosting the ROCE too much.
What We Can Learn From Software’s ROCE
This is good to see, and with a sound ROCE, Software could be worth a closer look. Of course you might be able to find a better stock than Software. So you may wish to see this free collection of other companies that have grown earnings strongly.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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 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.