Today we are going to look at Alpha Pro Tech, Ltd. (NYSEMKT:APT) to see whether it might be an attractive investment prospect. Specifically, we’ll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.
First up, we’ll look at what ROCE is and how we calculate it. Second, we’ll look at its ROCE compared to similar companies. Finally, we’ll look at how its current liabilities affect its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. 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?
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 Alpha Pro Tech:
0.12 = US$3.9m ÷ (US$34m – US$1.9m) (Based on the trailing twelve months to December 2018.)
So, Alpha Pro Tech has an ROCE of 12%.
Does Alpha Pro Tech Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. In this analysis, Alpha Pro Tech’s ROCE appears meaningfully below the 15% average reported by the Building industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Independently of how Alpha Pro Tech compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
As we can see, Alpha Pro Tech currently has an ROCE of 12% compared to its ROCE 3 years ago, which was 4.0%. This makes us wonder if the company is improving.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. 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 only a point-in-time measure. You can check if Alpha Pro Tech has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Do Alpha Pro Tech’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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Alpha Pro Tech has total assets of US$34m and current liabilities of US$1.9m. Therefore its current liabilities are equivalent to approximately 5.6% of its total assets. Low current liabilities have only a minimal impact on Alpha Pro Tech’s ROCE, making its decent returns more credible.
What We Can Learn From Alpha Pro Tech’s ROCE
If it is able to keep this up, Alpha Pro Tech could be attractive. But note: Alpha Pro Tech 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).
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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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.