Today we'll evaluate Constellation Software Inc. (TSE:CSU) 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.
First up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. All else being equal, a better business will have a higher ROCE. In brief, it is a useful tool, but it is not without drawbacks. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.
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 Constellation Software:
0.30 = US$520m ÷ (US$3.5b - US$1.7b) (Based on the trailing twelve months to December 2019.)
Therefore, Constellation Software has an ROCE of 30%.
Does Constellation Software Have A Good ROCE?
One way to assess ROCE is to compare similar companies. In our analysis, Constellation Software's ROCE is meaningfully higher than the 11% average in the Software industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Putting aside its position relative to its industry for now, in absolute terms, Constellation Software's ROCE is currently very good.
You can click on the image below to see (in greater detail) how Constellation Software'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 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 Constellation Software.
What Are Current Liabilities, And How Do They Affect Constellation Software's 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Constellation Software has total assets of US$3.5b and current liabilities of US$1.7b. Therefore its current liabilities are equivalent to approximately 50% of its total assets. A medium level of current liabilities boosts Constellation Software's ROCE somewhat.
Our Take On Constellation Software's ROCE
Even so, it has a great ROCE, and could be an attractive prospect for further research. There might be better investments than Constellation Software 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.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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.
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