This analysis is intended to introduce important early concepts to people who are starting to invest and looking to gauge the potential return on investment in Iberdrola SA (BME:IBE).
If you purchase a IBE share you are effectively becoming a partner with many other shareholders. As a result, your investment is being put to work to fund operations and if you want to earn an attractive return on your investment, the business needs to be making an adequate amount of money from the funds you provide. This is because the actual cash flow generated by the business dictates the potential for income (dividends) and capital appreciation (price increases), which are the two ways to achieve positive returns when buying a stock. Thus, to understand how your money can grow by investing in Iberdrola, you need to look at what the company returns to owners for the use of their capital, which can be done in many ways but today we will use return on capital employed (ROCE).
What is Return on Capital Employed (ROCE)?
Choosing to invest in Iberdrola comes at the cost of investing in another potentially favourable company. Therefore all else aside, your investment in a certain company represents a vote of confidence that the money used to buy the stock will grow larger than if invested elsewhere. So the business’ ability to grow the size of your capital is very important and can be assessed by comparing the return on capital you can get on your investment with a hurdle rate that depends on the other return possibilities you can identify. To determine Iberdrola’s capital return we will use ROCE, which tells us how much the company makes from the capital employed in their operations (for things like machinery, wages etc). IBE’s ROCE is calculated below:
ROCE Calculation for IBE
Return on Capital Employed (ROCE) = Earnings Before Tax (EBT) ÷ (Capital Employed)
Capital Employed = (Total Assets – Current Liabilities)
∴ ROCE = €3.1b ÷ (€112b – €18b) = 4.4%
IBE’s 4.4% ROCE means that for every €100 you invest, the company creates €4.4. This shows Iberdrola provides an unsatisfying capital return that is well below the 15% ROCE that is typically considered to be a strong benchmark. Nevertheless, if IBE is clever with their reinvestments or dividend payments, investors can still grow their capital although to a poor extent.
What is causing this?
The underperforming ROCE is not ideal for Iberdrola investors if the company is unable to turn things around. But if the underlying variables (earnings and capital employed) improve, IBE’s ROCE may increase, in which case your portfolio could benefit from holding the company. Because of this, it is important to look beyond the final value of IBE’s ROCE and understand what is happening to the individual components. If you go back three years, you’ll find that IBE’s ROCE has decreased from 5.0%. With this, the current earnings of €3.1b actually declined from €3.2b whilst capital employed has increased due to an increase in total assets employed , which means the company’s ROCE has shrunk as a result of falling earnings and simultaneous increases in capital requirements.
Iberdrola’s ROCE has decreased in the recent past and is currently at a level that makes us question whether the company is capable of providing a suitable return on investment. But don’t forget, return on capital employed is a static metric that should be looked at in conjunction with other fundamental indicators like future prospects and valuation. Iberdrola’s fundamentals can be explored with the links I’ve provided below if you are interested, otherwise you can start looking at other high-performing stocks.
- Future Outlook: What are well-informed industry analysts predicting for IBE’s future growth? Take a look at our free research report of analyst consensus for IBE’s outlook.
- Valuation: What is IBE worth today? Despite the unattractive ROCE, is the outlook correctly factored in to the price? The intrinsic value infographic in our free research report helps visualize whether IBE is currently undervalued by the market.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.