Today we are going to look at Illinois Tool Works Inc. (NYSE:ITW) to see whether it might be an attractive investment prospect. 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, 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.
Return On Capital Employed (ROCE): What is it?
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?
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 Illinois Tool Works:
0.31 = US$3.4b ÷ (US$15b – US$3.7b) (Based on the trailing twelve months to September 2018.)
So, Illinois Tool Works has an ROCE of 31%.
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Is Illinois Tool Works’s ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. In our analysis, Illinois Tool Works’s ROCE is meaningfully higher than the 12% average in the Machinery industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Putting aside its position relative to its industry for now, in absolute terms, Illinois Tool Works’s ROCE is currently very good.
As we can see, Illinois Tool Works currently has an ROCE of 31% compared to its ROCE 3 years ago, which was 21%. This makes us wonder if the company is improving.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. 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 Illinois Tool Works.
What Are Current Liabilities, And How Do They Affect Illinois Tool Works’s ROCE?
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.
Illinois Tool Works has total assets of US$15b and current liabilities of US$3.7b. Therefore its current liabilities are equivalent to approximately 24% of its total assets. The fairly low level of current liabilities won’t have much impact on the already great ROCE.
The Bottom Line On Illinois Tool Works’s ROCE
This is good to see, and with such a high ROCE, Illinois Tool Works may be worth a closer look. But note: Illinois Tool Works may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.