Today we'll evaluate Link Administration Holdings Limited (ASX:LNK) to determine whether it could have potential as an investment idea. 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, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Finally, we'll look at how its current liabilities affect its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. 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 Link Administration Holdings:
0.053 = AU$191m ÷ (AU$4.9b - AU$1.3b) (Based on the trailing twelve months to June 2019.)
So, Link Administration Holdings has an ROCE of 5.3%.
Does Link Administration Holdings Have A Good ROCE?
One way to assess ROCE is to compare similar companies. Using our data, Link Administration Holdings's ROCE appears to be significantly below the 15% average in the IT industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Setting aside the industry comparison for now, Link Administration Holdings's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.
We can see that , Link Administration Holdings currently has an ROCE of 5.3%, less than the 10% it reported 3 years ago. This makes us wonder if the business is facing new challenges. You can click on the image below to see (in greater detail) how Link Administration Holdings's past growth compares to other companies.
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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Do Link Administration Holdings'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. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Link Administration Holdings has total assets of AU$4.9b and current liabilities of AU$1.3b. Therefore its current liabilities are equivalent to approximately 27% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.
Our Take On Link Administration Holdings's ROCE
If Link Administration Holdings continues to earn an uninspiring ROCE, there may be better places to invest. Of course, you might also be able to find a better stock than Link Administration Holdings. So you may wish to see this free collection of other companies that have grown earnings strongly.
I will like Link Administration Holdings better if I see some big insider buys. While we wait, check out this free list 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 firstname.lastname@example.org. 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.