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Today we'll evaluate First Derivatives plc (LON:FDP) 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. Then we'll compare its ROCE 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 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 First Derivatives:
0.11 = UK£20m ÷ (UK£273m - UK£88m) (Based on the trailing twelve months to August 2018.)
Therefore, First Derivatives has an ROCE of 11%.
Does First Derivatives Have A Good ROCE?
One way to assess ROCE is to compare similar companies. Using our data, First Derivatives's ROCE appears to be around the 11% average of the IT industry. Independently of how First Derivatives compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
As we can see, First Derivatives currently has an ROCE of 11% compared to its ROCE 3 years ago, which was 5.5%. This makes us think about whether the company has been reinvesting shrewdly.
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 only a point-in-time measure. Since the future is so important for investors, you should check out our free report on analyst forecasts for First Derivatives.
First Derivatives's Current Liabilities And Their Impact On Its ROCE
Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that 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 counter this, investors can check if a company has high current liabilities relative to total assets.
First Derivatives has total assets of UK£273m and current liabilities of UK£88m. Therefore its current liabilities are equivalent to approximately 32% of its total assets. First Derivatives has a middling amount of current liabilities, increasing its ROCE somewhat.
Our Take On First Derivatives's ROCE
While its ROCE looks good, it's worth remembering that the current liabilities are making the business look better. Of course you might be able to find a better stock than First Derivatives. So you may wish to see this free collection of other companies that have grown earnings strongly.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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 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. Thank you for reading.