Today we'll evaluate British American Tobacco p.l.c. (LON:BATS) 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 up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting 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. Generally speaking a higher ROCE is better. Ultimately, it is a useful but imperfect metric. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.'
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 British American Tobacco:
0.079 = UK£10b ÷ (UK£148b - UK£20b) (Based on the trailing twelve months to June 2019.)
So, British American Tobacco has an ROCE of 7.9%.
Is British American Tobacco's ROCE Good?
One way to assess ROCE is to compare similar companies. Using our data, British American Tobacco's ROCE appears to be significantly below the 16% average in the Tobacco industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Setting aside the industry comparison for now, British American Tobacco's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.
We can see that , British American Tobacco currently has an ROCE of 7.9%, less than the 20% it reported 3 years ago. So investors might consider if it has had issues recently. The image below shows how British American Tobacco's ROCE compares to its industry, and you can click it to see more detail on its 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, 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 British American Tobacco.
British American Tobacco's Current Liabilities And Their Impact On Its ROCE
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counteract this, we check if a company has high current liabilities, relative to its total assets.
British American Tobacco has total assets of UK£148b and current liabilities of UK£20b. Therefore its current liabilities are equivalent to approximately 13% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.
What We Can Learn From British American Tobacco's ROCE
If British American Tobacco continues to earn an uninspiring ROCE, there may be better places to invest. You might be able to find a better investment than British American Tobacco. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
I will like British American Tobacco 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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If you spot an error that warrants correction, please contact the editor at email@example.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.