Today we’ll evaluate Gullewa Limited (ASX:GUL) 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. 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 measures the ‘return’ (pre-tax profit) a company generates from capital employed in its business. In general, businesses with a higher ROCE are usually better quality. In brief, it is a useful tool, but it is not without drawbacks. 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 Gullewa:
0.17 = AU$1.1m ÷ (AU$6.9m – AU$45k) (Based on the trailing twelve months to June 2018.)
So, Gullewa has an ROCE of 17%.
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Does Gullewa Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. In our analysis, Gullewa’s ROCE is meaningfully higher than the 12% average in the Metals and Mining industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Independently of how Gullewa compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
Gullewa reported an ROCE of 17% — better than 3 years ago, when the company didn’t make a profit. That implies the business has been improving.
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. Remember that most companies like Gullewa are cyclical businesses. You can check if Gullewa has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Do Gullewa’s Current Liabilities Skew 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Gullewa has total assets of AU$6.9m and current liabilities of AU$45k. Therefore its current liabilities are equivalent to approximately 0.7% of its total assets. In addition to low current liabilities (making a negligible impact on ROCE), Gullewa earns a sound return on capital employed.
Our Take On Gullewa’s ROCE
If it is able to keep this up, Gullewa could be attractive. You might be able to find a better buy than Gullewa. 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).
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.