Today we'll evaluate Charles & Colvard, Ltd. (NASDAQ:CTHR) to determine whether it could have potential as an investment idea. 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.
Firstly, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect 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. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. 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 Charles & Colvard:
0.057 = US$2.7m ÷ (US$51m - US$4.7m) (Based on the trailing twelve months to June 2019.)
Therefore, Charles & Colvard has an ROCE of 5.7%.
Is Charles & Colvard's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. We can see Charles & Colvard's ROCE is meaningfully below the Luxury industry average of 12%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Regardless of how Charles & Colvard stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). There are potentially more appealing investments elsewhere.
Charles & Colvard has an ROCE of 5.7%, but it didn't have an ROCE 3 years ago, since it was unprofitable. This makes us wonder if the company is improving. You can click on the image below to see (in greater detail) how Charles & Colvard's past growth compares to other companies.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during 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 Charles & Colvard.
Do Charles & Colvard's Current Liabilities Skew 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Charles & Colvard has total assets of US$51m and current liabilities of US$4.7m. Therefore its current liabilities are equivalent to approximately 9.2% of its total assets. Charles & Colvard has a low level of current liabilities, which have a negligible impact on its already low ROCE.
What We Can Learn From Charles & Colvard's ROCE
Still, investors could probably find more attractive prospects with better performance out there. You might be able to find a better investment than Charles & Colvard. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
I will like Charles & Colvard better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider 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.