Today we'll look at Devro plc (LON:DVO) and reflect on its potential as an investment. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.
First, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. 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 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. Overall, it is a valuable metric that has its flaws. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.
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 Devro:
0.098 = UK£38m ÷ (UK£421m - UK£33m) (Based on the trailing twelve months to June 2019.)
Therefore, Devro has an ROCE of 9.8%.
Does Devro Have A Good ROCE?
One way to assess ROCE is to compare similar companies. We can see Devro's ROCE is around the 11% average reported by the Food industry. Independently of how Devro compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
You can click on the image below to see (in greater detail) how Devro's past growth compares to other companies.
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 deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is only a point-in-time measure. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
How Devro's Current Liabilities Impact Its ROCE
Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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.
Devro has total liabilities of UK£33m and total assets of UK£421m. Therefore its current liabilities are equivalent to approximately 7.8% of its total assets. Low current liabilities have only a minimal impact on Devro's ROCE, making its decent returns more credible.
What We Can Learn From Devro's ROCE
If it is able to keep this up, Devro could be attractive. There might be better investments than Devro 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.
I will like Devro better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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