Today we are going to look at Alfa Laval AB (publ) (STO:ALFA) 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.
Firstly, 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. All else being equal, a better business will have a higher ROCE. 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 Alfa Laval:
0.15 = kr6.5b ÷ (kr66b - kr24b) (Based on the trailing twelve months to September 2019.)
Therefore, Alfa Laval has an ROCE of 15%.
Is Alfa Laval's ROCE Good?
One way to assess ROCE is to compare similar companies. We can see Alfa Laval's ROCE is around the 16% average reported by the Machinery industry. Separate from Alfa Laval's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
You can see in the image below how Alfa Laval's ROCE compares to its industry. Click to see more on past growth.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is, after all, simply a snap shot of a single year. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Alfa Laval.
How Alfa Laval's Current Liabilities Impact Its 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 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Alfa Laval has total assets of kr66b and current liabilities of kr24b. As a result, its current liabilities are equal to approximately 36% of its total assets. Alfa Laval has a middling amount of current liabilities, increasing its ROCE somewhat.
What We Can Learn From Alfa Laval's ROCE
With a decent ROCE, the company could be interesting, but remember that the level of current liabilities make the ROCE look better. Alfa Laval looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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.
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. Thank you for reading.