Today we’ll evaluate Cadence Design Systems, Inc. (NASDAQ:CDNS) to determine whether it could have potential as an investment idea. 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. Then we’ll compare its ROCE to similar companies. And finally, we’ll look at how its current liabilities are impacting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its 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’.
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 Cadence Design Systems:
0.23 = US$407m ÷ (US$2.5b – US$709m) (Based on the trailing twelve months to December 2018.)
Therefore, Cadence Design Systems has an ROCE of 23%.
Does Cadence Design Systems Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. In our analysis, Cadence Design Systems’s ROCE is meaningfully higher than the 9.3% average in the Software industry. I think that’s good to see, since it implies the company is better than other companies at making the most of its capital. Putting aside its position relative to its industry for now, in absolute terms, Cadence Design Systems’s ROCE is currently very good.
Our data shows that Cadence Design Systems currently has an ROCE of 23%, compared to its ROCE of 16% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly.
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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Cadence Design Systems.
Cadence Design Systems’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.
Cadence Design Systems has total assets of US$2.5b and current liabilities of US$709m. As a result, its current liabilities are equal to approximately 29% of its total assets. A minimal amount of current liabilities limits the impact on ROCE.
The Bottom Line On Cadence Design Systems’s ROCE
This is good to see, and with such a high ROCE, Cadence Design Systems may be worth a closer look. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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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.