Today we are going to look at Champion Iron Limited (ASX:CIA) 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.
Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
What is 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. In general, businesses with a higher ROCE are usually better quality. 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?
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 Champion Iron:
0.59 = CA$386m ÷ (CA$799m - CA$147m) (Based on the trailing twelve months to June 2019.)
Therefore, Champion Iron has an ROCE of 59%.
Does Champion Iron Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. Using our data, we find that Champion Iron's ROCE is meaningfully better than the 9.1% average in the Metals and Mining industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Regardless of the industry comparison, in absolute terms, Champion Iron's ROCE currently appears to be excellent.
Champion Iron reported an ROCE of 59% -- better than 3 years ago, when the company didn't make a profit. That suggests the business has returned to profitability. You can click on the image below to see (in greater detail) how Champion Iron's past growth compares to other companies.
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. ROCE is, after all, simply a snap shot of a single year. We note Champion Iron could be considered a cyclical business. Since the future is so important for investors, you should check out our free report on analyst forecasts for Champion Iron.
Do Champion Iron'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 ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counteract this, we check if a company has high current liabilities, relative to its total assets.
Champion Iron has total liabilities of CA$147m and total assets of CA$799m. As a result, its current liabilities are equal to approximately 18% of its total assets. This is quite a low level of current liabilities which would not greatly boost the already high ROCE.
What We Can Learn From Champion Iron's ROCE
This is good to see, and with such a high ROCE, Champion Iron may be worth a closer look. There might be better investments than Champion Iron out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
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 firstname.lastname@example.org. 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.