Today we'll evaluate Diodes Incorporated (NASDAQ:DIOD) 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 of all, we'll work out how to calculate ROCE. Second, we'll look at its ROCE compared 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 measures the 'return' (pre-tax profit) a company generates from capital employed 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?
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 Diodes:
0.14 = US$181m ÷ (US$1.6b - US$275m) (Based on the trailing twelve months to June 2019.)
Therefore, Diodes has an ROCE of 14%.
Is Diodes's ROCE Good?
One way to assess ROCE is to compare similar companies. Diodes's ROCE appears to be substantially greater than the 10% average in the Semiconductor 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. Regardless of where Diodes sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
Our data shows that Diodes currently has an ROCE of 14%, compared to its ROCE of 1.4% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly. You can click on the image below to see (in greater detail) how Diodes'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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Since the future is so important for investors, you should check out our free report on analyst forecasts for Diodes.
Do Diodes's Current Liabilities Skew 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Diodes has total liabilities of US$275m and total assets of US$1.6b. Therefore its current liabilities are equivalent to approximately 17% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.
What We Can Learn From Diodes's ROCE
This is good to see, and with a sound ROCE, Diodes could be worth a closer look. There might be better investments than Diodes 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 Diodes better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider 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 firstname.lastname@example.org. 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.