Today we'll evaluate Humana Inc. (NYSE:HUM) to determine whether it could have potential as an investment idea. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into 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.
Return On Capital Employed (ROCE): What is it?
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. 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'.
So, How Do We Calculate ROCE?
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 Humana:
0.19 = US$3.4b ÷ (US$29b - US$11b) (Based on the trailing twelve months to September 2019.)
Therefore, Humana has an ROCE of 19%.
Does Humana Have A Good ROCE?
One way to assess ROCE is to compare similar companies. Using our data, we find that Humana's ROCE is meaningfully better than the 11% average in the Healthcare industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Independently of how Humana compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
We can see that, Humana currently has an ROCE of 19% compared to its ROCE 3 years ago, which was 15%. This makes us think about whether the company has been reinvesting shrewdly. The image below shows how Humana's ROCE compares to its industry, and you can click it to see more detail on its past growth.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. 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 Humana.
Do Humana's Current Liabilities Skew Its 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.
Humana has total assets of US$29b and current liabilities of US$11b. Therefore its current liabilities are equivalent to approximately 38% of its total assets. Humana has a middling amount of current liabilities, increasing its ROCE somewhat.
What We Can Learn From Humana's ROCE
While its ROCE looks good, it's worth remembering that the current liabilities are making the business look better. Humana shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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.
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