What Should Investors Know About Southwest Airlines Co’s (NYSE:LUV) Return On Capital?

The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want a simplistic look at the return on Southwest Airlines Co (NYSE:LUV) stock.

Purchasing Southwest Airlines gives you an ownership stake in the company. Your equity share is granted in return for the capital provided to the business to operate, and in order for an investment to be successful the business has to create earnings from the funds that make up this capital. Your return is tied to LUV’s ability to do this because the amount earned is used to invest in opportunities to grow the business or payout dividends, which are the two sources of return on investment. To understand Southwest Airlines’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.

See our latest analysis for Southwest Airlines

Calculating Return On Capital Employed for LUV

When you choose to invest in a company, there is an opportunity cost because that money could’ve been invested elsewhere. 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. To determine Southwest Airlines’s capital return we will use ROCE, which tells us how much the company makes from the capital employed in their operations (for things like machinery, wages etc). I have calculated Southwest Airlines’s ROCE for you below:

ROCE Calculation for LUV

Return on Capital Employed (ROCE) = Earnings Before Tax (EBT) ÷ (Capital Employed)

Capital Employed = (Total Assets – Current Liabilities)

∴ ROCE = US$3.0b ÷ (US$27b – US$7.8b) = 17%

As you can see, LUV earned $17 from every $100 you invested over the previous twelve months. This shows Southwest Airlines 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 LUV is clever with their reinvestments or dividend payments, investors can grow their capital at an attractive rate over time.

NYSE:LUV Last Perf November 20th 18
NYSE:LUV Last Perf November 20th 18

Can any of this change?

The encouraging ROCE is good news for Southwest Airlines investors if the company is able to maintain strong earnings and control their capital needs. But if this doesn’t occur, LUV’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 LUV’s ROCE and understand what is happening to the individual components. If you go back three years, you’ll find that LUV’s ROCE has decreased from 26%. Over the same period, EBT went from US$2.2b to US$3.0b but capital employed has grown by a proportionally greater amount in response to an increase in total assets , which means that although earnings have increased, LUV requires more capital to produce each $1 of earnings.

Next Steps

ROCE for LUV investors has declined in the last few years, however, the company still remains an attractive candidate that is capable of producing solid capital returns and a potentially strong return on investment. Before making any decisions, ROCE does not tell the whole picture so you need to pay attention to other fundamentals like future prospects and valuation. Without considering these fundamentals, you cannot be sure if the downward path is a signal to run, or just a blip in an otherwise solid return profile. Southwest Airlines’s fundamentals can be explored with the links I’ve provided below if you are interested, otherwise you can start looking at other high-performing stocks.

  1. Future Outlook: What are well-informed industry analysts predicting for LUV’s future growth? Take a look at our free research report of analyst consensus for LUV’s outlook.
  2. Valuation: What is LUV 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 LUV is currently mispriced by the market.
  3. 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 editorial-team@simplywallst.com.