Why You Should Care About Royal Mail plc’s (LON:RMG) Low Return On Capital

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Today we are going to look at Royal Mail plc (LON:RMG) to see whether it might be an attractive investment prospect. 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 of all, we'll work out how to calculate ROCE. Next, we'll compare it to others in its industry. Last but not least, we'll look at what impact its current liabilities have on its ROCE.

Return On Capital Employed (ROCE): What is it?

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. In brief, it is a useful tool, but it is not without drawbacks. 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 Royal Mail:

0.10 = UK£545m ÷ (UK£7.4b - UK£2.0b) (Based on the trailing twelve months to March 2019.)

So, Royal Mail has an ROCE of 10%.

View our latest analysis for Royal Mail

Does Royal Mail Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. We can see Royal Mail's ROCE is meaningfully below the Logistics industry average of 13%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Separate from Royal Mail'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 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 Royal Mail.

How Royal Mail's Current Liabilities Impact 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.

Royal Mail has total assets of UK£7.4b and current liabilities of UK£2.0b. As a result, its current liabilities are equal to approximately 27% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.

Our Take On Royal Mail's ROCE

Overall, Royal Mail has a decent ROCE and could be worthy of further research. Royal Mail looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.

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