Today we are going to look at American Water Works Company, Inc. (NYSE:AWK) 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. Then we’ll compare its ROCE to similar companies. 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. Ultimately, it is a useful but imperfect metric. 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?
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 American Water Works Company:
0.06 = US$1.1b ÷ (US$21b – US$2.1b) (Based on the trailing twelve months to December 2018.)
Therefore, American Water Works Company has an ROCE of 6.0%.
Does American Water Works Company Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. Using our data, we find that American Water Works Company’s ROCE is meaningfully better than the 4.9% average in the Water Utilities industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Setting aside the industry comparison for now, American Water Works Company’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.
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 deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is, after all, simply a snap shot of a single year. Since the future is so important for investors, you should check out our free report on analyst forecasts for American Water Works Company.
What Are Current Liabilities, And How Do They Affect American Water Works Company’s ROCE?
Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
American Water Works Company has total assets of US$21b and current liabilities of US$2.1b. As a result, its current liabilities are equal to approximately 9.9% of its total assets. With low levels of current liabilities, at least American Water Works Company’s mediocre ROCE is not unduly boosted.
Our Take On American Water Works Company’s ROCE
American Water Works Company looks like an ok business, but on this analysis it is not at the top of our buy list. You might be able to find a better investment than American Water Works Company. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
If you like to buy stocks alongside management, then you might just love this free list 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 email@example.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.