Today we'll evaluate Samuel Heath & Sons plc (LON:HSM) 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, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Then we'll determine how its current liabilities are affecting its ROCE.
Understanding 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 Samuel Heath & Sons:
0.10 = UK£1.2m ÷ (UK£14m - UK£2.0m) (Based on the trailing twelve months to September 2019.)
So, Samuel Heath & Sons has an ROCE of 10%.
Is Samuel Heath & Sons's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. It appears that Samuel Heath & Sons's ROCE is fairly close to the Building industry average of 10%. Regardless of where Samuel Heath & Sons sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
You can click on the image below to see (in greater detail) how Samuel Heath & Sons's past growth compares to other companies.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. How cyclical is Samuel Heath & Sons? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
How Samuel Heath & Sons's Current Liabilities Impact Its ROCE
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counteract this, we check if a company has high current liabilities, relative to its total assets.
Samuel Heath & Sons has total liabilities of UK£2.0m and total assets of UK£14m. As a result, its current liabilities are equal to approximately 14% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
What We Can Learn From Samuel Heath & Sons's ROCE
Overall, Samuel Heath & Sons has a decent ROCE and could be worthy of further research. There might be better investments than Samuel Heath & Sons 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.
Samuel Heath & Sons is not the only stock insiders are buying. So take a peek at this free list of growing companies with insider buying.
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