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Today we are going to look at International Business Machines Corporation (NYSE:IBM) 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. Finally, we'll look at how its current liabilities affect its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Generally speaking a higher ROCE is better. Ultimately, it is a useful but imperfect metric. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.'
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 International Business Machines:
0.13 = US$12b ÷ (US$131b - US$39b) (Based on the trailing twelve months to March 2019.)
Therefore, International Business Machines has an ROCE of 13%.
Does International Business Machines Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that International Business Machines's ROCE is meaningfully better than the 9.7% average in the IT industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Independently of how International Business Machines compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
As we can see, International Business Machines currently has an ROCE of 13%, less than the 18% it reported 3 years ago. This makes us wonder if the business is facing new challenges.
Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately 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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
How International Business Machines's Current Liabilities Impact Its ROCE
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.
International Business Machines has total liabilities of US$39b and total assets of US$131b. Therefore its current liabilities are equivalent to approximately 30% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
What We Can Learn From International Business Machines's ROCE
With that in mind, International Business Machines's ROCE appears pretty good. There might be better investments than International Business Machines out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
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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.