This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between Red Hat Inc (NYSE:RHT)’s return fundamentals and stock market performance.
If you purchase a RHT share you are effectively becoming a partner with many other shareholders. Owing to this, it is important that the underlying business is producing a sufficient amount of income from the capital invested by stockholders. This is because the actual cash flow generated by the business dictates the potential for income (dividends) and capital appreciation (price increases), which are the two ways to achieve positive returns when buying a stock. To understand Red Hat’s capital returns we will look at a useful metric called return on capital employed. This will tell us if the company is growing your capital and placing you in good stead to sell your shares at a profit.
Red Hat’s Return On Capital Employed
As an investor you have many alternative companies to choose from, which means there is an opportunity cost in any investment you make in the form of a foregone investment in another company. The cost of missing out on another opportunity comes in the form of the potential long term gain you could’ve received, which is dependent on the gap between the return on capital you could’ve achieved and that of the company you invested in. Hence, capital returns are very important, and should be examined before you invest in conjunction with a certain benchmark that represents the minimum return you require to be compensated for the risk of missing out on other potentially lucrative investments. We’ll look at Red Hat’s returns by computing return on capital employed, which will tell us what the company can generate from the money spent in operations. Take a look at the formula box beneath:
ROCE Calculation for RHT
Return on Capital Employed (ROCE) = Earnings Before Tax (EBT) ÷ (Capital Employed)
Capital Employed = (Total Assets – Current Liabilities)
∴ ROCE = US$488.53m ÷ (US$5.19b – US$2.28b) = 16.76%
As you can see, RHT earned $16.8 from every $100 you invested over the previous twelve months. This shows Red Hat provides a favourable return to capital holders, which beats the 15% ROCE that is typically considered to be a strong benchmark. As a result, if RHT is clever with their reinvestments or dividend payments, investors can grow their capital at an attractive rate over time.
Can any of this change?
The encouraging ROCE is good news for Red Hat investors if the company is able to maintain strong earnings and control their capital needs. But if this doesn’t occur, RHT’s ROCE may deteriorate, in which case your money is better invested elsewhere. Because of this, it is important to look beyond the final value of RHT’s ROCE and understand what is happening to the individual components. Looking at the past 3 year period shows us that RHT boosted investor return on capital employed from 10.73%. Similarly, the movement in the earnings variable shows a jump from US$269.92m to US$488.53m whilst capital employed also increased but to a smaller extent, which means the company has been able to improve ROCE by driving up earnings relative to the capital invested in the business.
Red Hat’s ROCE has increased in the recent past and is above a benchmark that makes the company a potentially attractive stock that can achieve a solid return on investment. As an investor this is the type of situation you look for, but return on capital employed is a static metric that should be looked at in conjunction with other fundamental indicators like future prospects and valuation. It’s important to account for these factors because you cannot be sure if this trend will continue or if you are getting a good deal for the future returns you are paying for. If you’re interested in diving deeper, take a look at what I’ve linked below for further information on these fundamentals and other potential investment opportunities.
- Future Outlook: What are well-informed industry analysts predicting for RHT’s future growth? Take a look at our free research report of analyst consensus for RHT’s outlook.
- Valuation: What is RHT worth today? Is the stock undervalued, even if its ROCE is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether RHT is currently mispriced by the market.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
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 firstname.lastname@example.org.