Today we'll look at Pacific Star Network Limited (ASX:PNW) and reflect on its potential as an investment. Specifically, we'll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.
First of all, we'll work out how to calculate ROCE. Then we'll compare its ROCE to similar companies. Then we'll determine how its current liabilities are affecting 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. 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?
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 Pacific Star Network:
0.11 = AU$6.5m ÷ (AU$71m - AU$13m) (Based on the trailing twelve months to June 2019.)
So, Pacific Star Network has an ROCE of 11%.
Is Pacific Star Network's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. We can see Pacific Star Network's ROCE is around the 9.5% average reported by the Media industry. Regardless of where Pacific Star Network sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
You can see in the image below how Pacific Star Network's ROCE compares to its industry. Click to see more on past growth.
Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. How cyclical is Pacific Star Network? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
How Pacific Star Network'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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Pacific Star Network has current liabilities of AU$13m and total assets of AU$71m. Therefore its current liabilities are equivalent to approximately 18% of its total assets. Low current liabilities are not boosting the ROCE too much.
What We Can Learn From Pacific Star Network's ROCE
Overall, Pacific Star Network has a decent ROCE and could be worthy of further research. Pacific Star Network 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.
I will like Pacific Star Network better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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