U.S. Markets closed

Is Eaton Corporation plc's (NYSE:ETN) Capital Allocation Ability Worth Your Time?

Simply Wall St

Today we'll look at Eaton Corporation plc (NYSE:ETN) 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.

Firstly, we'll go over how we 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.

What is 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. All else being equal, a better business will have a higher ROCE. Overall, it is a valuable metric that has its flaws. 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?

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 Eaton:

0.11 = US$3.0b ÷ (US$32b - US$5.3b) (Based on the trailing twelve months to March 2019.)

Therefore, Eaton has an ROCE of 11%.

View our latest analysis for Eaton

Does Eaton Have A Good ROCE?

One way to assess ROCE is to compare similar companies. Using our data, Eaton's ROCE appears to be around the 11% average of the Electrical industry. Independently of how Eaton compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

We can see that , Eaton currently has an ROCE of 11% compared to its ROCE 3 years ago, which was 8.7%. This makes us think the business might be improving. You can click on the image below to see (in greater detail) how Eaton's past growth compares to other companies.

NYSE:ETN Past Revenue and Net Income, July 24th 2019

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. ROCE is only a point-in-time measure. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Eaton.

How Eaton's Current Liabilities Impact Its ROCE

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 counter this, investors can check if a company has high current liabilities relative to total assets.

Eaton has total liabilities of US$5.3b and total assets of US$32b. As a result, its current liabilities are equal to approximately 17% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.

Our Take On Eaton's ROCE

Overall, Eaton has a decent ROCE and could be worthy of further research. There might be better investments than Eaton 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.

If you are like me, then you will not want to miss this free list of growing companies that insiders are 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 editorial-team@simplywallst.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.