Why We’re Not Impressed By Luna Innovations Incorporated’s (NASDAQ:LUNA) 2.6% ROCE

Today we'll look at Luna Innovations Incorporated (NASDAQ:LUNA) and reflect on its potential as an investment. 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 up, we'll look at what ROCE is and how we calculate it. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Generally speaking a higher ROCE is better. 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'.

How Do You Calculate Return On Capital Employed?

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 Luna Innovations:

0.026 = US$1.7m ÷ (US$76m - US$12m) (Based on the trailing twelve months to December 2018.)

So, Luna Innovations has an ROCE of 2.6%.

See our latest analysis for Luna Innovations

Is Luna Innovations's ROCE Good?

One way to assess ROCE is to compare similar companies. Using our data, Luna Innovations's ROCE appears to be significantly below the 11% average in the Electronic industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Regardless of how Luna Innovations stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). It is likely that there are more attractive prospects out there.

Luna Innovations reported an ROCE of 2.6% -- better than 3 years ago, when the company didn't make a profit. That implies the business has been improving.

When considering ROCE, bear in mind that it reflects the past and does not necessarily 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. 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 freereport on analyst forecasts for Luna Innovations.

What Are Current Liabilities, And How Do They Affect Luna Innovations's ROCE?

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

Luna Innovations has total assets of US$76m and current liabilities of US$12m. Therefore its current liabilities are equivalent to approximately 16% of its total assets. This is not a high level of current liabilities, which would not boost the ROCE by much.

The Bottom Line On Luna Innovations's ROCE

Luna Innovations has a poor ROCE, and there may be better investment prospects out there. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this freelist of companies with modest (or no) debt, trading on a P/E below 20.

I will like Luna Innovations better if I see some big insider buys. While we wait, check out this freelist 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.