Examining Select Medical Holdings Corporation’s (NYSE:SEM) Weak Return On Capital Employed

Today we are going to look at Select Medical Holdings Corporation (NYSE:SEM) to see whether it might be an attractive investment prospect. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

Firstly, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect 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. In general, businesses with a higher ROCE are usually better quality. 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?

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 Select Medical Holdings:

0.078 = US$359m ÷ (US$6.0b - US$685m) (Based on the trailing twelve months to September 2018.)

So, Select Medical Holdings has an ROCE of 7.8%.

Check out our latest analysis for Select Medical Holdings

Is Select Medical Holdings's ROCE Good?

ROCE is commonly used for comparing the performance of similar businesses. In this analysis, Select Medical Holdings's ROCE appears meaningfully below the 13% average reported by the Healthcare industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Aside from the industry comparison, Select Medical Holdings's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Readers may find more attractive investment prospects elsewhere.

When considering ROCE, bear in mind that it reflects the past and does not necessarily 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. Since the future is so important for investors, you should check out our freereport on analyst forecasts for Select Medical Holdings.

What Are Current Liabilities, And How Do They Affect Select Medical Holdings's ROCE?

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counteract this, we check if a company has high current liabilities, relative to its total assets.

Select Medical Holdings has total liabilities of US$685m and total assets of US$6.0b. Therefore its current liabilities are equivalent to approximately 11% of its total assets. It is good to see a restrained amount of current liabilities, as this limits the effect on ROCE.

What We Can Learn From Select Medical Holdings's ROCE

With that in mind, we're not overly impressed with Select Medical Holdings's ROCE, so it may not be the most appealing prospect. Of course you might be able to find a better stock than Select Medical Holdings. So you may wish to see this freecollection of other companies that have grown earnings strongly.

If you like to buy stocks alongside management, then you might just love this freelist of companies. (Hint: insiders have been buying them).

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 editorial-team@simplywallst.com.

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.