Today we'll evaluate Meridian Energy Limited (NZSE:MEL) 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 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.
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. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.
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 Meridian Energy:
0.069 = NZ$620m ÷ (NZ$9.7b - NZ$620m) (Based on the trailing twelve months to June 2019.)
Therefore, Meridian Energy has an ROCE of 6.9%.
Does Meridian Energy Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. Using our data, Meridian Energy's ROCE appears to be around the 8.0% average of the Renewable Energy industry. Setting aside the industry comparison for now, Meridian Energy's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.
In our analysis, Meridian Energy's ROCE appears to be 6.9%, compared to 3 years ago, when its ROCE was 5.0%. This makes us wonder if the company is improving. Take a look at the image below to see how Meridian Energy's past growth compares to the average in its industry.
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. 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.
Meridian Energy'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. 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.
Meridian Energy has total assets of NZ$9.7b and current liabilities of NZ$620m. Therefore its current liabilities are equivalent to approximately 6.4% of its total assets. Meridian Energy has a low level of current liabilities, which have a minimal impact on its uninspiring ROCE.
What We Can Learn From Meridian Energy's ROCE
Based on this information, Meridian Energy appears to be a mediocre business. Of course, you might also be able to find a better stock than Meridian Energy. So you may wish to see this free collection of other companies that have grown earnings strongly.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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 email@example.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.