Today we are going to look at American Electric Power Company, Inc. (NYSE:AEP) 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. Next, we'll compare it to others in its industry. Then we'll determine how its current liabilities are affecting its ROCE.
Return On Capital Employed (ROCE): What is it?
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. Overall, it is a valuable metric that has its flaws. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.'
So, How Do We Calculate ROCE?
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 American Electric Power Company:
0.043 = US$2.8b ÷ (US$73b - US$8.4b) (Based on the trailing twelve months to June 2019.)
So, American Electric Power Company has an ROCE of 4.3%.
Is American Electric Power Company's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. It appears that American Electric Power Company's ROCE is fairly close to the Electric Utilities industry average of 4.9%. Independently of how American Electric Power Company compares to its industry, its ROCE in absolute terms is low; especially compared to the ~2.7% available in government bonds. There are potentially more appealing investments elsewhere.
American Electric Power Company's current ROCE of 4.3% is lower than 3 years ago, when the company reported a 5.7% ROCE. This makes us wonder if the business is facing new challenges. The image below shows how American Electric Power Company's ROCE compares to its industry, and you can click it to see more detail on its past growth.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for American Electric Power Company.
What Are Current Liabilities, And How Do They Affect American Electric Power Company's 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
American Electric Power Company has total liabilities of US$8.4b and total assets of US$73b. Therefore its current liabilities are equivalent to approximately 12% of its total assets. This is a modest level of current liabilities, which will have a limited impact on the ROCE.
Our Take On American Electric Power Company's ROCE
While that is good to see, American Electric Power Company has a low ROCE and does not look attractive in this analysis. Of course, you might also be able to find a better stock than American Electric Power Company. So you may wish to see this free collection of other companies that have grown earnings strongly.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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.