Are Pitti Engineering Limited’s (NSE:PITTIENG) High Returns Really That Great?

Today we are going to look at Pitti Engineering Limited (NSE:PITTIENG) 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 of all, we'll work out how to calculate ROCE. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Generally speaking a higher ROCE is better. 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?

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 Pitti Engineering:

0.25 = ₹684m ÷ (₹5.4b - ₹2.7b) (Based on the trailing twelve months to December 2018.)

So, Pitti Engineering has an ROCE of 25%.

View our latest analysis for Pitti Engineering

Is Pitti Engineering's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. In our analysis, Pitti Engineering's ROCE is meaningfully higher than the 15% average in the Electrical 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 Pitti Engineering's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

Our data shows that Pitti Engineering currently has an ROCE of 25%, compared to its ROCE of 7.8% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly.

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 misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Future performance is what matters, and you can see analyst predictions in our freereport on analyst forecasts for the company.

Pitti Engineering's Current Liabilities And Their Impact On 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. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counter this, investors can check if a company has high current liabilities relative to total assets.

Pitti Engineering has total liabilities of ₹2.7b and total assets of ₹5.4b. Therefore its current liabilities are equivalent to approximately 49% of its total assets. With this level of current liabilities, Pitti Engineering's ROCE is boosted somewhat.

Our Take On Pitti Engineering's ROCE

Pitti Engineering's ROCE does look good, but the level of current liabilities also contribute to that. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this freelist of companies with modest (or no) debt, trading on a P/E below 20.

I will like Pitti Engineering better if I see some big insider buys. While we wait, check out this freelist 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.