Today we’ll evaluate Otelco Inc. (NASDAQ:OTEL) to determine whether it could have potential as an investment idea. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. Then we’ll determine how its current liabilities are affecting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the ‘return’ (pre-tax profit) a company generates from capital employed in its business. All else being equal, a better business will have a higher ROCE. 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?
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 Otelco:
0.18 = US$20m ÷ (US$114m – US$13m) (Based on the trailing twelve months to September 2018.)
So, Otelco has an ROCE of 18%.
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Does Otelco Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. In our analysis, Otelco’s ROCE is meaningfully higher than the 6.0% average in the Telecom industry. I think that’s good to see, since it implies the company is better than other companies at making the most of its capital. Separate from Otelco’s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
As we can see, Otelco currently has an ROCE of 18%, less than the 232% it reported 3 years ago. So investors might consider if it has had issues recently.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. How cyclical is Otelco? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
Do Otelco’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 counter this, investors can check if a company has high current liabilities relative to total assets.
Otelco has total liabilities of US$13m and total assets of US$114m. Therefore its current liabilities are equivalent to approximately 11% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
What We Can Learn From Otelco’s ROCE
Overall, Otelco has a decent ROCE and could be worthy of further research. Of course you might be able to find a better stock than Otelco. So you may wish to see this free collection of other companies that have grown earnings strongly.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.