Today we are going to look at Deswell Industries, Inc. (NASDAQ:DSWL) to see whether it might be an attractive investment prospect. 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. Next, we’ll compare it to others in its industry. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE measures the ‘return’ (pre-tax profit) a company generates from capital employed in its business. In general, businesses with a higher ROCE are usually better quality. In brief, it is a useful tool, but it is not without drawbacks. 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 Deswell Industries:
0.024 = US$2.0m ÷ (US$103m – US$18m) (Based on the trailing twelve months to September 2019.)
Therefore, Deswell Industries has an ROCE of 2.4%.
Does Deswell Industries Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. We can see Deswell Industries’s ROCE is meaningfully below the Electronic industry average of 10%. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Independently of how Deswell Industries compares to its industry, its ROCE in absolute terms is low; especially compared to the ~2.2% available in government bonds. It is likely that there are more attractive prospects out there.
Deswell Industries has an ROCE of 2.4%, but it didn’t have an ROCE 3 years ago, since it was unprofitable. That suggests the business has returned to profitability. You can see in the image below how Deswell Industries’s ROCE compares to its industry. Click to see more on past growth.
Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately 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, after all, simply a snap shot of a single year. If Deswell Industries is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
Do Deswell Industries’s Current Liabilities Skew 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 ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counter this, investors can check if a company has high current liabilities relative to total assets.
Deswell Industries has total assets of US$103m and current liabilities of US$18m. Therefore its current liabilities are equivalent to approximately 18% of its total assets. This is not a high level of current liabilities, which would not boost the ROCE by much.
What We Can Learn From Deswell Industries’s ROCE
That’s not a bad thing, however Deswell Industries has a weak ROCE and may not be an attractive investment. Of course, you might also be able to find a better stock than Deswell Industries. So you may wish to see this free collection of other companies that have grown earnings strongly.
Deswell Industries is not the only stock insiders are buying. So take a peek at this free list of growing companies with insider buying.
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.