Here’s why Dialight plc’s (LON:DIA) Returns On Capital Matters So Much

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Today we are going to look at Dialight plc (LON:DIA) 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, we’ll go over how we calculate ROCE. Then we’ll compare its ROCE to similar companies. Finally, we’ll look at how its current liabilities affect its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. In general, businesses with a higher ROCE are usually better quality. 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 Dialight:

0.073 = UK£9.5m ÷ (UK£105m – UK£25m) (Based on the trailing twelve months to June 2018.)

So, Dialight has an ROCE of 7.3%.

View our latest analysis for Dialight

Does Dialight Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. In this analysis, Dialight’s ROCE appears meaningfully below the 14% average reported by the Electrical industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Setting aside the industry comparison for now, Dialight’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.

Dialight’s current ROCE of 7.3% is lower than its ROCE in the past, which was 19%, 3 years ago. So investors might consider if it has had issues recently.

LSE:DIA Past Revenue and Net Income, February 22nd 2019
LSE:DIA Past Revenue and Net Income, February 22nd 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. 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 Dialight.

Dialight’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.

Dialight has total assets of UK£105m and current liabilities of UK£25m. Therefore its current liabilities are equivalent to approximately 23% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.

Our Take On Dialight’s ROCE

With that in mind, we’re not overly impressed with Dialight’s ROCE, so it may not be the most appealing prospect. Of course you might be able to find a better stock than Dialight. So you may wish to see this free collection of other companies that have grown earnings strongly.

I will like Dialight 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.