Today we'll evaluate Emerson Electric Co. (NYSE:EMR) to determine whether it could have potential as an investment idea. 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.
Understanding 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. 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 Emerson Electric:
0.21 = US$3.1b ÷ (US$20b - US$6.0b) (Based on the trailing twelve months to September 2019.)
So, Emerson Electric has an ROCE of 21%.
Is Emerson Electric's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. In our analysis, Emerson Electric's ROCE is meaningfully higher than the 10% average in the Electrical 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, Emerson Electric's ROCE in absolute terms currently looks quite high.
The image below shows how Emerson Electric's ROCE compares to its industry, and you can click it to see more detail on its past growth.
Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is, after all, simply a snap shot of a single year. Since the future is so important for investors, you should check out our free report on analyst forecasts for Emerson Electric.
Do Emerson Electric's Current Liabilities Skew Its ROCE?
Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that need to be paid within 12 months. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Emerson Electric has total liabilities of US$6.0b and total assets of US$20b. Therefore its current liabilities are equivalent to approximately 29% of its total assets. A minimal amount of current liabilities limits the impact on ROCE.
Our Take On Emerson Electric's ROCE
, There might be better investments than Emerson Electric 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.
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