Today we’ll look at Avalon Holdings Corporation (NYSEMKT:AWX) and reflect on its potential as an investment. 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, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared 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 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. 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?
Analysts use this formula to calculate return on capital employed:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
Or for Avalon Holdings:
0.014 = -US$271.0k ÷ (US$68m – US$16m) (Based on the trailing twelve months to September 2018.)
So, Avalon Holdings has an ROCE of 1.4%.
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Is Avalon Holdings’s ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, Avalon Holdings’s ROCE appears to be significantly below the 11% average in the Commercial Services industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Putting aside Avalon Holdings’s performance relative to its industry, its ROCE in absolute terms is poor – considering the risk of owning stocks compared to government bonds. It is likely that there are more attractive prospects out there.
Avalon Holdings delivered an ROCE of 1.4%, which is better than 3 years ago, as was making losses back then. This makes us wonder if the company is improving.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. 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. If Avalon Holdings is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
What Are Current Liabilities, And How Do They Affect Avalon Holdings’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. 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.
Avalon Holdings has total liabilities of US$16m and total assets of US$68m. Therefore its current liabilities are equivalent to approximately 24% of its total assets. This is not a high level of current liabilities, which would not boost the ROCE by much.
What We Can Learn From Avalon Holdings’s ROCE
While that is good to see, Avalon Holdings has a low ROCE and does not look attractive in this analysis. Of course you might be able to find a better stock than Avalon Holdings. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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 email@example.com.