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Should You Care About Semtech Corporation’s (NASDAQ:SMTC) Investment Potential?

Simply Wall St

Today we are going to look at Semtech Corporation (NASDAQ:SMTC) 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.

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.

What is 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. All else being equal, a better business will have a higher ROCE. Ultimately, it is a useful but imperfect metric. 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'.

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 Semtech:

0.092 = US$87m ÷ (US$1.1b - US$111m) (Based on the trailing twelve months to July 2019.)

So, Semtech has an ROCE of 9.2%.

See our latest analysis for Semtech

Is Semtech's ROCE Good?

ROCE is commonly used for comparing the performance of similar businesses. It appears that Semtech's ROCE is fairly close to the Semiconductor industry average of 10%. Setting aside the industry comparison for now, Semtech's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Readers may find more attractive investment prospects elsewhere.

We can see that , Semtech currently has an ROCE of 9.2% compared to its ROCE 3 years ago, which was 5.0%. This makes us think the business might be improving. You can click on the image below to see (in greater detail) how Semtech's past growth compares to other companies.

NasdaqGS:SMTC Past Revenue and Net Income, September 17th 2019

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. ROCE is only a point-in-time measure. Since the future is so important for investors, you should check out our free report on analyst forecasts for Semtech.

Do Semtech'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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Semtech has total liabilities of US$111m and total assets of US$1.1b. As a result, its current liabilities are equal to approximately 10% of its total assets. It is good to see a restrained amount of current liabilities, as this limits the effect on ROCE.

What We Can Learn From Semtech's ROCE

That said, Semtech's ROCE is mediocre, there may be more attractive investments around. Of course, you might also be able to find a better stock than Semtech. So you may wish to see this free collection of other companies that have grown earnings strongly.

If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.

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 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. Thank you for reading.