Today we are going to look at VMware, Inc. (NYSE:VMW) to see whether it might be an attractive investment prospect. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First up, we'll look at what ROCE is and how we calculate it. Second, we'll look at its ROCE compared to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. All else being equal, a better business will have a higher ROCE. 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?
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 VMware:
0.15 = US$2.1b ÷ (US$22b - US$7.9b) (Based on the trailing twelve months to November 2019.)
Therefore, VMware has an ROCE of 15%.
Does VMware Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. VMware's ROCE appears to be substantially greater than the 9.8% average in the Software industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Separate from VMware's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
You can click on the image below to see (in greater detail) how VMware's past growth compares to other companies.
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. ROCE is only a point-in-time measure. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for VMware.
How VMware's Current Liabilities Impact 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 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 counter this, investors can check if a company has high current liabilities relative to total assets.
VMware has total liabilities of US$7.9b and total assets of US$22b. Therefore its current liabilities are equivalent to approximately 36% of its total assets. With this level of current liabilities, VMware's ROCE is boosted somewhat.
What We Can Learn From VMware's ROCE
VMware's ROCE does look good, but the level of current liabilities also contribute to that. VMware looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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