Why Alliance Data Systems Corporation’s (NYSE:ADS) Return On Capital Employed Might Be A Concern

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Today we’ll look at Alliance Data Systems Corporation (NYSE:ADS) and reflect on its potential as an investment. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the 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.

What is Return On Capital Employed (ROCE)?

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. In brief, it is a useful tool, but it is not without drawbacks. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.’

How Do You Calculate Return On Capital Employed?

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 Alliance Data Systems:

0.079 = US$1.5b ÷ (US$29b – US$11b) (Based on the trailing twelve months to March 2019.)

Therefore, Alliance Data Systems has an ROCE of 7.9%.

See our latest analysis for Alliance Data Systems

Does Alliance Data Systems Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. Using our data, Alliance Data Systems’s ROCE appears to be significantly below the 10% average in the IT industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Setting aside the industry comparison for now, Alliance Data Systems’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.

NYSE:ADS Past Revenue and Net Income, May 31st 2019
NYSE:ADS Past Revenue and Net Income, May 31st 2019

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. Since the future is so important for investors, you should check out our free report on analyst forecasts for Alliance Data Systems.

How Alliance Data Systems’s Current Liabilities Impact Its ROCE

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.

Alliance Data Systems has total assets of US$29b and current liabilities of US$11b. As a result, its current liabilities are equal to approximately 36% of its total assets. Alliance Data Systems’s ROCE is improved somewhat by its moderate amount of current liabilities.

Our Take On Alliance Data Systems’s ROCE

Unfortunately, its ROCE is still uninspiring, and there are potentially more attractive prospects out there. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

I will like Alliance Data Systems better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

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 editorial-team@simplywallst.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.