Today we'll evaluate Treasury Wine Estates Limited (ASX:TWE) 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.
Understanding 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. 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'.
How Do You Calculate Return On Capital Employed?
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 Treasury Wine Estates:
0.13 = AU$672m ÷ (AU$6.0b - AU$885m) (Based on the trailing twelve months to June 2019.)
Therefore, Treasury Wine Estates has an ROCE of 13%.
Is Treasury Wine Estates's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. In our analysis, Treasury Wine Estates's ROCE is meaningfully higher than the 9.8% average in the Beverage 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 Treasury Wine Estates's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
Our data shows that Treasury Wine Estates currently has an ROCE of 13%, compared to its ROCE of 7.1% 3 years ago. This makes us think the business might be improving. The image below shows how Treasury Wine Estates'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. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is only a point-in-time measure. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Treasury Wine Estates.
Do Treasury Wine Estates'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.
Treasury Wine Estates has total liabilities of AU$885m and total assets of AU$6.0b. As a result, its current liabilities are equal to approximately 15% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
What We Can Learn From Treasury Wine Estates's ROCE
With that in mind, Treasury Wine Estates's ROCE appears pretty good. Treasury Wine Estates shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
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 email@example.com. 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.