Frontier Developments plc (LON:FDEV) Earns A Nice Return On Capital Employed

Today we'll look at Frontier Developments plc (LON:FDEV) 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 up, we'll look at what ROCE is and how we calculate it. 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 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. 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 Frontier Developments:

0.25 = UK£17m ÷ (UK£84m - UK£15m) (Based on the trailing twelve months to November 2018.)

Therefore, Frontier Developments has an ROCE of 25%.

Check out our latest analysis for Frontier Developments

Is Frontier Developments's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. In our analysis, Frontier Developments's ROCE is meaningfully higher than the 9.8% average in the Entertainment industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Setting aside the comparison to its industry for a moment, Frontier Developments's ROCE in absolute terms currently looks quite high.

In our analysis, Frontier Developments's ROCE appears to be 25%, compared to 3 years ago, when its ROCE was 17%. This makes us wonder if the company is improving.

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, after all, simply a snap shot of a single year. Since the future is so important for investors, you should check out our freereport on analyst forecasts for Frontier Developments.

Do Frontier Developments's Current Liabilities Skew 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 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.

Frontier Developments has total assets of UK£84m and current liabilities of UK£15m. Therefore its current liabilities are equivalent to approximately 17% of its total assets. The fairly low level of current liabilities won't have much impact on the already great ROCE.

Our Take On Frontier Developments's ROCE

This is good to see, and with such a high ROCE, Frontier Developments may be worth a closer look. You might be able to find a better buy than Frontier Developments. If you want a selection of possible winners, check out this freelist of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

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