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Should You Like Altium Limited’s (ASX:ALU) High Return On Capital Employed?

Hector Vargas

Today we are going to look at Altium Limited (ASX:ALU) to see whether it might be an attractive investment prospect. In particular, we’ll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

First up, we’ll look at what ROCE is and how we calculate it. Then we’ll compare its ROCE to similar companies. Then we’ll determine how its current liabilities are affecting its ROCE.

What is 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. In brief, it is a useful tool, but it is not without drawbacks. 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 Altium:

0.28 = US$48m ÷ (US$234m – US$64m) (Based on the trailing twelve months to June 2018.)

So, Altium has an ROCE of 28%.

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Does Altium Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. Using our data, we find that Altium’s ROCE is meaningfully better than the 20% average in the Software industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Setting aside the comparison to its industry for a moment, Altium’s ROCE in absolute terms currently looks quite high.

As we can see, Altium currently has an ROCE of 28% compared to its ROCE 3 years ago, which was 19%. This makes us wonder if the company is improving.

ASX:ALU Last Perf January 13th 19

Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during 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 free report on analyst forecasts for Altium.

Do Altium’s Current Liabilities Skew Its ROCE?

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Altium has total assets of US$234m and current liabilities of US$64m. Therefore its current liabilities are equivalent to approximately 27% of its total assets. The fairly low level of current liabilities won’t have much impact on the already great ROCE.

The Bottom Line On Altium’s ROCE

With low current liabilities and a high ROCE, Altium could be worthy of further investigation. You might be able to find a better buy than Altium. 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 are like me, then you will not want to miss this free list of growing companies that insiders are buying.

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.