Today we are going to look at Red Hat, Inc. (NYSE:RHT) to see whether it might be an attractive investment prospect. To be precise, we’ll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
First of all, we’ll work out how to calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. Then we’ll determine how its current liabilities are affecting its ROCE.
Understanding 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. 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 Red Hat:
0.19 = US$515m ÷ (US$5.1b – US$2.4b) (Based on the trailing twelve months to November 2018.)
Therefore, Red Hat has an ROCE of 19%.
Is Red Hat’s ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. In our analysis, Red Hat’s ROCE is meaningfully higher than the 9.4% average in the Software industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Independently of how Red Hat compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
As we can see, Red Hat currently has an ROCE of 19% compared to its ROCE 3 years ago, which was 11%. This makes us think about whether the company has been reinvesting shrewdly.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is only a point-in-time measure. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
What Are Current Liabilities, And How Do They Affect Red Hat’s ROCE?
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. 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.
Red Hat has total assets of US$5.1b and current liabilities of US$2.4b. Therefore its current liabilities are equivalent to approximately 46% of its total assets. Red Hat has a middling amount of current liabilities, increasing its ROCE somewhat.
The Bottom Line On Red Hat’s ROCE
While its ROCE looks good, it’s worth remembering that the current liabilities are making the business look better. But note: Red Hat may not be the best stock to buy. 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 Red Hat 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 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.