Today we'll evaluate Energy Recovery, Inc. (NASDAQ:ERII) to determine whether it could have potential as an investment idea. 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. Finally, we'll look at how its current liabilities affect its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. Ultimately, it is a useful but imperfect metric. 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 Energy Recovery:
0.068 = US$11m ÷ (US$189m - US$28m) (Based on the trailing twelve months to December 2019.)
Therefore, Energy Recovery has an ROCE of 6.8%.
Does Energy Recovery Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. In this analysis, Energy Recovery's ROCE appears meaningfully below the 11% average reported by the Machinery industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Separate from how Energy Recovery stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. It is possible that there are more rewarding investments out there.
Our data shows that Energy Recovery currently has an ROCE of 6.8%, compared to its ROCE of 2.6% 3 years ago. This makes us think the business might be improving. You can click on the image below to see (in greater detail) how Energy Recovery's past growth compares to other companies.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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. Since the future is so important for investors, you should check out our free report on analyst forecasts for Energy Recovery.
How Energy Recovery's Current Liabilities Impact Its ROCE
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.
Energy Recovery has current liabilities of US$28m and total assets of US$189m. Therefore its current liabilities are equivalent to approximately 15% 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 Energy Recovery's ROCE
If Energy Recovery continues to earn an uninspiring ROCE, there may be better places to invest. Of course, you might also be able to find a better stock than Energy Recovery. So you may wish to see this free collection of other companies that have grown earnings strongly.
I will like Energy Recovery better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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