Today we’ll evaluate W.W. Grainger, Inc. (NYSE:GWW) to determine whether it could have potential as an investment idea. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
Firstly, we’ll go over how we calculate ROCE. Then we’ll compare its ROCE to similar companies. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.
Understanding 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. 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’.
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 W.W. Grainger:
0.31 = US$1.4b ÷ (US$5.9b – US$1.5b) (Based on the trailing twelve months to December 2018.)
Therefore, W.W. Grainger has an ROCE of 31%.
Does W.W. Grainger Have A Good ROCE?
One way to assess ROCE is to compare similar companies. W.W. Grainger’s ROCE appears to be substantially greater than the 8.2% average in the Trade Distributors 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. Regardless of the industry comparison, in absolute terms, W.W. Grainger’s ROCE currently appears to be excellent.
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 W.W. Grainger.
Do W.W. Grainger’s Current Liabilities Skew 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
W.W. Grainger has total assets of US$5.9b and current liabilities of US$1.5b. As a result, its current liabilities are equal to approximately 26% of its total assets. The fairly low level of current liabilities won’t have much impact on the already great ROCE.
What We Can Learn From W.W. Grainger’s ROCE
With low current liabilities and a high ROCE, W.W. Grainger could be worthy of further investigation. W.W. Grainger shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
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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.