Today we’ll evaluate Freeport-McMoRan Inc. (NYSE:FCX) 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, 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 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. 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’.
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 Freeport-McMoRan:
0.12 = US$4.6b ÷ (US$42b – US$3.3b) (Based on the trailing twelve months to December 2018.)
Therefore, Freeport-McMoRan has an ROCE of 12%.
Is Freeport-McMoRan’s ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. We can see Freeport-McMoRan’s ROCE is around the 11% average reported by the Metals and Mining industry. Separate from Freeport-McMoRan’s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
As we can see, Freeport-McMoRan currently has an ROCE of 12% compared to its ROCE 3 years ago, which was 0.1%. 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. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Given the industry it operates in, Freeport-McMoRan could be considered cyclical. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
What Are Current Liabilities, And How Do They Affect Freeport-McMoRan’s ROCE?
Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Freeport-McMoRan has total assets of US$42b and current liabilities of US$3.3b. Therefore its current liabilities are equivalent to approximately 7.9% of its total assets. Low current liabilities have only a minimal impact on Freeport-McMoRan’s ROCE, making its decent returns more credible.
The Bottom Line On Freeport-McMoRan’s ROCE
If it is able to keep this up, Freeport-McMoRan could be attractive. 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.
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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.