Today we'll evaluate The Gap, Inc. (NYSE:GPS) to determine whether it could have potential as an investment idea. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the 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.
What is Return On Capital Employed (ROCE)?
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. 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?
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 Gap:
0.12 = US$1.3b ÷ (US$14b - US$2.8b) (Based on the trailing twelve months to May 2019.)
So, Gap has an ROCE of 12%.
Does Gap Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. It appears that Gap's ROCE is fairly close to the Specialty Retail industry average of 11%. Independently of how Gap compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
We can see that , Gap currently has an ROCE of 12%, less than the 30% it reported 3 years ago. Therefore we wonder if the company is facing new headwinds. You can click on the image below to see (in greater detail) how Gap'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, after all, simply a snap shot of a single year. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Gap.
Do Gap's Current Liabilities Skew Its ROCE?
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that 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.
Gap has total assets of US$14b and current liabilities of US$2.8b. Therefore its current liabilities are equivalent to approximately 21% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.
The Bottom Line On Gap's ROCE
This is good to see, and with a sound ROCE, Gap could be worth a closer look. There might be better investments than Gap 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.
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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.