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Today we'll evaluate Lenovo Group Limited (HKG:992) 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.
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. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
Understanding 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?
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 Lenovo Group:
0.16 = US$1.3b ÷ (US$31b - US$23b) (Based on the trailing twelve months to December 2018.)
Therefore, Lenovo Group has an ROCE of 16%.
Does Lenovo Group Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. Lenovo Group's ROCE appears to be substantially greater than the 6.6% average in the Tech 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 Lenovo Group's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
Our data shows that Lenovo Group currently has an ROCE of 16%, compared to its ROCE of 4.4% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly.
It is important to remember that ROCE shows past performance, and is 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Lenovo Group.
What Are Current Liabilities, And How Do They Affect Lenovo Group's ROCE?
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.
Lenovo Group has total liabilities of US$23b and total assets of US$31b. Therefore its current liabilities are equivalent to approximately 73% of its total assets. Lenovo Group has a relatively high level of current liabilities, boosting its ROCE meaningfully.
The Bottom Line On Lenovo Group's ROCE
The ROCE would not look as appealing if the company had fewer current liabilities. But note: Lenovo Group may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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 email@example.com. 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.