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Today we’ll look at Analog Devices, Inc. (NASDAQ:ADI) and reflect on its potential as an investment. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First of all, we’ll work out how to calculate ROCE. Then we’ll compare its ROCE to similar companies. And finally, we’ll look at how its current liabilities are impacting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the business. Generally speaking a higher ROCE is better. In brief, it is a useful tool, but it is not without drawbacks. 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 Analog Devices:
0.10 = US$1.9b ÷ (US$20b – US$1.4b) (Based on the trailing twelve months to November 2018.)
So, Analog Devices has an ROCE of 10%.
Does Analog Devices Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. We can see Analog Devices’s ROCE is meaningfully below the Semiconductor industry average of 14%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Separate from how Analog Devices stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. It is possible that there are more rewarding investments out there.
Analog Devices’s current ROCE of 10% is lower than 3 years ago, when the company reported a 14% ROCE. Therefore we wonder if the company is facing new headwinds.
When considering ROCE, bear in mind that it reflects the past and does not necessarily 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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
What Are Current Liabilities, And How Do They Affect Analog Devices’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 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Analog Devices has total assets of US$20b and current liabilities of US$1.4b. Therefore its current liabilities are equivalent to approximately 6.9% of its total assets. Analog Devices has a low level of current liabilities, which have a minimal impact on its uninspiring ROCE.
What We Can Learn From Analog Devices’s ROCE
Analog Devices 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 buy than Analog Devices. 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).
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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. On rare occasion, data errors may occur. Thank you for reading.