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Today we’ll evaluate Illinois Tool Works Inc. (NYSE:ITW) 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.
First, 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.
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’.
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 Illinois Tool Works:
0.31 = US$3.5b ÷ (US$15b – US$4.0b) (Based on the trailing twelve months to March 2019.)
Therefore, Illinois Tool Works has an ROCE of 31%.
Does Illinois Tool Works Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. Using our data, we find that Illinois Tool Works’s ROCE is meaningfully better than the 11% average in the Machinery industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Regardless of the industry comparison, in absolute terms, Illinois Tool Works’s ROCE currently appears to be excellent.
In our analysis, Illinois Tool Works’s ROCE appears to be 31%, compared to 3 years ago, when its ROCE was 23%. This makes us think the business might be improving.
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 free report on analyst forecasts for the company.
Do Illinois Tool Works’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. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Illinois Tool Works has total assets of US$15b and current liabilities of US$4.0b. As a result, its current liabilities are equal to approximately 26% of its total assets. This is quite a low level of current liabilities which would not greatly boost the already high ROCE.
The Bottom Line On Illinois Tool Works’s ROCE
Low current liabilities and high ROCE is a good combination, making Illinois Tool Works look quite interesting. Illinois Tool Works 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.
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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 firstname.lastname@example.org. 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.