Canadian Pacific Railway Limited (TSE:CP) Earns A Nice Return On Capital Employed
Today we are going to look at Canadian Pacific Railway Limited (TSE:CP) to see whether it might be an attractive investment prospect. Specifically, we'll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.
First up, we'll look at what ROCE is and how we calculate it. Second, we'll look at its ROCE compared to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. In general, businesses with a higher ROCE are usually better quality. Ultimately, it is a useful but imperfect metric. 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?
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 Canadian Pacific Railway:
0.17 = CA$3.5b ÷ (CA$23b - CA$2.1b) (Based on the trailing twelve months to September 2019.)
So, Canadian Pacific Railway has an ROCE of 17%.
See our latest analysis for Canadian Pacific Railway
Does Canadian Pacific Railway Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. Canadian Pacific Railway's ROCE appears to be substantially greater than the 11% average in the Transportation industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Regardless of where Canadian Pacific Railway sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
You can see in the image below how Canadian Pacific Railway's ROCE compares to its industry. Click to see more on past growth.
Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. 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 Canadian Pacific Railway.
How Canadian Pacific Railway's Current Liabilities Impact Its ROCE
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Canadian Pacific Railway has total assets of CA$23b and current liabilities of CA$2.1b. As a result, its current liabilities are equal to approximately 9.3% of its total assets. In addition to low current liabilities (making a negligible impact on ROCE), Canadian Pacific Railway earns a sound return on capital employed.
What We Can Learn From Canadian Pacific Railway's ROCE
If Canadian Pacific Railway can continue reinvesting in its business, it could be an attractive prospect. Canadian Pacific Railway 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.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.
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