Here’s why Gooch & Housego PLC’s (LON:GHH) Returns On Capital Matters So Much

Today we’ll evaluate Gooch & Housego PLC (LON:GHH) 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 up, we’ll look at what ROCE is and how we calculate it. Next, we’ll compare it to others in its industry. And finally, we’ll look at how its current liabilities are impacting 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. 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’.

So, How Do We Calculate ROCE?

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 Gooch & Housego:

0.062 = UK£9.1m ÷ (UK£174m – UK£28m) (Based on the trailing twelve months to March 2019.)

Therefore, Gooch & Housego has an ROCE of 6.2%.

Is Gooch & Housego’s ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. We can see Gooch & Housego’s ROCE is meaningfully below the Electronic industry average of 12%. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Aside from the industry comparison, Gooch & Housego’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.

Gooch & Housego’s current ROCE of 6.2% is lower than its ROCE in the past, which was 10%, 3 years ago. Therefore we wonder if the company is facing new headwinds.

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 free report on analyst forecasts for Gooch & Housego.

What Are Current Liabilities, And How Do They Affect Gooch & Housego’s ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Gooch & Housego has total assets of UK£174m and current liabilities of UK£28m. As a result, its current liabilities are equal to approximately 16% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.

The Bottom Line On Gooch & Housego’s ROCE

If Gooch & Housego continues to earn an uninspiring ROCE, there may be better places to invest. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

I will like Gooch & Housego 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.