Today we'll evaluate Lenovo Group Limited (HKG:992) to determine whether it could have potential as an investment idea. 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. Next, we'll compare it to others in its industry. Then we'll determine how its current liabilities are affecting its ROCE.
Return On Capital Employed (ROCE): What is it?
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. Ultimately, it is a useful but imperfect metric. 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:
0.13 = US$1.2b ÷ (US$32b - US$23b) (Based on the trailing twelve months to June 2019.)
Therefore, Lenovo Group has an ROCE of 13%.
Does Lenovo Group Have A Good ROCE?
One way to assess ROCE is to compare similar companies. Using our data, we find that Lenovo Group's ROCE is meaningfully better than the 6.9% average in the Tech industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Independently of how Lenovo Group compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
We can see that, Lenovo Group currently has an ROCE of 13% compared to its ROCE 3 years ago, which was 6.1%. This makes us think about whether the company has been reinvesting shrewdly. The image below shows how Lenovo Group's ROCE compares to its industry, and you can click it to see more detail on its 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 misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is, after all, simply a snap shot of a single year. Since the future is so important for investors, you should check out our free report on analyst forecasts for Lenovo Group.
How Lenovo Group's Current Liabilities Impact Its ROCE
Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counter this, investors can check if a company has high current liabilities relative to total assets.
Lenovo Group has total liabilities of US$23b and total assets of US$32b. Therefore its current liabilities are equivalent to approximately 70% of its total assets. This is admittedly a high level of current liabilities, improving ROCE substantially.
What We Can Learn From Lenovo Group's ROCE
This ROCE is pretty good, but remember that it would look less impressive with fewer current liabilities. Lenovo Group 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.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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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.