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Today we'll evaluate Insteel Industries, Inc. (NASDAQ:IIIN) 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.
First, 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 metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. All else being equal, a better business will have a higher ROCE. 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'.
How Do You Calculate Return On Capital Employed?
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 Insteel Industries:
0.024 = US$6.5m ÷ (US$319m - US$48m) (Based on the trailing twelve months to March 2020.)
So, Insteel Industries has an ROCE of 2.4%.
Is Insteel Industries's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. We can see Insteel Industries's ROCE is meaningfully below the Building industry average of 12%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Independently of how Insteel Industries compares to its industry, its ROCE in absolute terms is low; especially compared to the ~1.7% available in government bonds. There are potentially more appealing investments elsewhere.
We can see that, Insteel Industries currently has an ROCE of 2.4%, less than the 25% it reported 3 years ago. So investors might consider if it has had issues recently. You can see in the image below how Insteel Industries'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. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is, after all, simply a snap shot of a single year. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Insteel Industries.
Do Insteel Industries's Current Liabilities Skew 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Insteel Industries has current liabilities of US$48m and total assets of US$319m. As a result, its current liabilities are equal to approximately 15% of its total assets. This is a modest level of current liabilities, which will have a limited impact on the ROCE.
What We Can Learn From Insteel Industries's ROCE
While that is good to see, Insteel Industries has a low ROCE and does not look attractive in this analysis. Of course, you might also be able to find a better stock than Insteel Industries. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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.
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