Today we'll evaluate Embelton Limited (ASX:EMB) 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.
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.
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'.
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 Embelton:
0.094 = AU$2.2m ÷ (AU$32m - AU$8.6m) (Based on the trailing twelve months to June 2019.)
So, Embelton has an ROCE of 9.4%.
Is Embelton's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, Embelton's ROCE appears to be around the 9.9% average of the Building industry. Setting aside the industry comparison for now, Embelton's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Readers may find more attractive investment prospects elsewhere.
Embelton's current ROCE of 9.4% is lower than 3 years ago, when the company reported a 17% ROCE. This makes us wonder if the business is facing new challenges. You can see in the image below how Embelton's ROCE compares to its industry. Click to see more on past growth.
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. You can check if Embelton has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Embelton's Current Liabilities And Their Impact On 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. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Embelton has total assets of AU$32m and current liabilities of AU$8.6m. Therefore its current liabilities are equivalent to approximately 27% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.
Our Take On Embelton's ROCE
If Embelton continues to earn an uninspiring ROCE, there may be better places to invest. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
I will like Embelton better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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.
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