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What Can We Make Of carsales.com Ltd’s (ASX:CAR) High Return On Capital?

Simply Wall St

Today we'll evaluate carsales.com Ltd (ASX:CAR) to determine whether it could have potential as an investment idea. 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. Next, we'll compare it to others in its industry. Then we'll determine how its current liabilities are affecting 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. All else being equal, a better business will have a higher ROCE. 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 carsales.com:

0.21 = AU$181m ÷ (AU$923m - AU$78m) (Based on the trailing twelve months to June 2019.)

So, carsales.com has an ROCE of 21%.

View our latest analysis for carsales.com

Does carsales.com Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. Using our data, we find that carsales.com's ROCE is meaningfully better than the 12% average in the Interactive Media and Services industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Setting aside the comparison to its industry for a moment, carsales.com's ROCE in absolute terms currently looks quite high.

carsales.com's current ROCE of 21% is lower than its ROCE in the past, which was 33%, 3 years ago. Therefore we wonder if the company is facing new headwinds. The image below shows how carsales.com's ROCE compares to its industry, and you can click it to see more detail on its past growth.

ASX:CAR Past Revenue and Net Income, August 21st 2019

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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

How carsales.com's Current Liabilities Impact 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 counter this, investors can check if a company has high current liabilities relative to total assets.

carsales.com has total assets of AU$923m and current liabilities of AU$78m. Therefore its current liabilities are equivalent to approximately 8.5% of its total assets. carsales.com has low current liabilities, which have a negligible impact on its relatively good ROCE.

What We Can Learn From carsales.com's ROCE

This suggests the company would be worth researching in more depth. carsales.com shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.

If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).

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.