Today we are going to look at The Cato Corporation (NYSE:CATO) to see whether it might be an attractive investment prospect. 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.
Firstly, we'll go over how we 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.
Return On Capital Employed (ROCE): What is it?
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. Generally speaking a higher ROCE is better. 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.
How Do You Calculate Return On Capital Employed?
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 Cato:
0.081 = US$38m ÷ (US$651m - US$187m) (Based on the trailing twelve months to November 2019.)
So, Cato has an ROCE of 8.1%.
Does Cato Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, Cato's ROCE appears to be significantly below the 11% average in the Specialty Retail industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Separate from how Cato 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.
Cato's current ROCE of 8.1% is lower than 3 years ago, when the company reported a 18% ROCE. This makes us wonder if the business is facing new challenges. You can click on the image below to see (in greater detail) how Cato's past growth compares to other companies.
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 deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is, after all, simply a snap shot of a single year. You can check if Cato has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Cato's Current Liabilities And Their Impact On Its ROCE
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Cato has total liabilities of US$187m and total assets of US$651m. Therefore its current liabilities are equivalent to approximately 29% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.
Our Take On Cato's ROCE
With that in mind, we're not overly impressed with Cato's ROCE, so it may not be the most appealing prospect. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
I will like Cato better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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