Today we’ll evaluate Alphabet Inc. (NASDAQ:GOOG.L) 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. 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 measures the ‘return’ (pre-tax profit) a company generates from capital employed in its business. All else being equal, a better business will have a higher ROCE. Overall, it is a valuable metric that has its flaws. 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 Alphabet:
0.15 = US$33b ÷ (US$263b – US$39b) (Based on the trailing twelve months to September 2019.)
Therefore, Alphabet has an ROCE of 15%.
Is Alphabet’s ROCE Good?
One way to assess ROCE is to compare similar companies. Alphabet’s ROCE appears to be substantially greater than the 9.0% average in the Interactive Media and Services industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of where Alphabet sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
You can see in the image below how Alphabet’s ROCE compares to its industry. Click to see more on past growth.
It is important to remember that ROCE shows past performance, and is 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, 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 Alphabet.
How Alphabet’s Current Liabilities Impact Its ROCE
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Alphabet has total liabilities of US$39b and total assets of US$263b. Therefore its current liabilities are equivalent to approximately 15% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
Our Take On Alphabet’s ROCE
Overall, Alphabet has a decent ROCE and could be worthy of further research. There might be better investments than Alphabet out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
I will like Alphabet better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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