What Can We Make Of National Grid plc’s (LON:NG.) High Return On Capital?

Today we'll look at National Grid plc (LON:NG.) and reflect on its potential as an investment. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

Firstly, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.

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

ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the 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. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.

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 National Grid:

0.067 = UK£3.6b ÷ (UK£63b - UK£9.1b) (Based on the trailing twelve months to March 2019.)

So, National Grid has an ROCE of 6.7%.

View our latest analysis for National Grid

Does National Grid Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. National Grid's ROCE appears to be substantially greater than the 5.1% average in the Integrated Utilities 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. Separate from how National Grid stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Investors may wish to consider higher-performing investments.

Take a look at the image below to see how National Grid's past growth compares to the average in its industry.

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. 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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

How National Grid'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 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.

National Grid has total liabilities of UK£9.1b and total assets of UK£63b. Therefore its current liabilities are equivalent to approximately 14% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.

What We Can Learn From National Grid's ROCE

If National Grid 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 National Grid 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.