Today we’ll look at Analog Devices, Inc. (NASDAQ:ADI) and reflect on its potential as an investment. 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, we’ll go over how we calculate ROCE. Then we’ll compare its ROCE to similar companies. Then we’ll determine how its current liabilities are affecting its ROCE.
What is 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. All else being equal, a better business will have a higher ROCE. 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 Analog Devices:
0.092 = US$1.9b ÷ (US$22b – US$850m) (Based on the trailing twelve months to February 2019.)
So, Analog Devices has an ROCE of 9.2%.
Does Analog Devices Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. In this analysis, Analog Devices’s ROCE appears meaningfully below the 13% average reported by the Semiconductor 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, Analog Devices’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.
Analog Devices’s current ROCE of 9.2% is lower than its ROCE in the past, which was 15%, 3 years ago. Therefore we wonder if the company is facing new headwinds.
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. ROCE is only a point-in-time measure. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Analog Devices.
Analog Devices’s Current Liabilities And Their Impact On 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.
Analog Devices has total liabilities of US$850m and total assets of US$22b. Therefore its current liabilities are equivalent to approximately 3.9% of its total assets. Analog Devices has a low level of current liabilities, which have a minimal impact on its uninspiring ROCE.
The Bottom Line On Analog Devices’s ROCE
If performance improves, then Analog Devices may be an OK investment, especially at the right valuation. Of course you might be able to find a better stock than Analog Devices. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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.