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Today we'll evaluate DS Smith Plc (LON:SMDS) 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. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting 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. 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?
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 DS Smith:
0.09 = UK£493m ÷ (UK£7.8b - UK£2.3b) (Based on the trailing twelve months to October 2018.)
So, DS Smith has an ROCE of 9.0%.
Does DS Smith Have A Good ROCE?
One way to assess ROCE is to compare similar companies. In our analysis, DS Smith's ROCE is meaningfully higher than the 5.3% average in the Packaging industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Aside from the industry comparison, DS Smith's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.
DS Smith's current ROCE of 9.0% is lower than 3 years ago, when the company reported a 13% ROCE. This makes us wonder if the business is facing new challenges.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for DS Smith.
How DS Smith'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. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
DS Smith has total assets of UK£7.8b and current liabilities of UK£2.3b. As a result, its current liabilities are equal to approximately 30% of its total assets. It is good to see a restrained amount of current liabilities, as this limits the effect on ROCE.
Our Take On DS Smith's ROCE
With that in mind, we're not overly impressed with DS Smith's ROCE, so it may not be the most appealing prospect. Of course, you might also be able to find a better stock than DS Smith. So you may wish to see this free collection of other companies that have grown earnings strongly.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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.