Should You Like HP Inc.’s (NYSE:HPQ) High Return On Capital Employed?

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Today we'll look at HP Inc. (NYSE:HPQ) and reflect on its potential as an investment. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Generally speaking a higher ROCE is better. 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?

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 HP:

0.46 = US$4.3b ÷ (US$35b - US$25b) (Based on the trailing twelve months to October 2018.)

So, HP has an ROCE of 46%.

Check out our latest analysis for HP

Does HP Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. Using our data, we find that HP's ROCE is meaningfully better than the 12% average in the Tech industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Putting aside its position relative to its industry for now, in absolute terms, HP's ROCE is currently very good.

In our analysis, HP's ROCE appears to be 46%, compared to 3 years ago, when its ROCE was 6.1%. This makes us think the business might be improving.

It is important to remember that ROCE shows past performance, and is 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Since the future is so important for investors, you should check out our freereport on analyst forecasts for HP.

How HP's Current Liabilities Impact Its ROCE

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counter this, investors can check if a company has high current liabilities relative to total assets.

HP has total assets of US$35b and current liabilities of US$25b. Therefore its current liabilities are equivalent to approximately 73% of its total assets. While a high level of current liabilities boosts its ROCE, HP's returns are still very good.

The Bottom Line On HP's ROCE

So to us, the company is potentially worth investigating further. Of course you might be able to find a better stock than HP. So you may wish to see this freecollection of other companies that have grown earnings strongly.

If you like to buy stocks alongside management, then you might just love this freelist of companies. (Hint: insiders have been buying them).

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.