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Should You Like LGI Homes, Inc.’s (NASDAQ:LGIH) High Return On Capital Employed?

Simply Wall St

Today we are going to look at LGI Homes, Inc. (NASDAQ:LGIH) to see whether it might be an attractive investment prospect. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

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.

Understanding Return On Capital Employed (ROCE)

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Generally speaking a higher ROCE is better. 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'.

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 LGI Homes:

0.14 = US$190m ÷ (US$1.5b - US$165m) (Based on the trailing twelve months to June 2019.)

So, LGI Homes has an ROCE of 14%.

Check out our latest analysis for LGI Homes

Is LGI Homes's ROCE Good?

ROCE is commonly used for comparing the performance of similar businesses. In our analysis, LGI Homes's ROCE is meaningfully higher than the 12% average in the Consumer Durables industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Separate from LGI Homes's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

The image below shows how LGI Homes's ROCE compares to its industry, and you can click it to see more detail on its past growth.

NasdaqGS:LGIH Past Revenue and Net Income, October 2nd 2019

When considering ROCE, bear in mind that it reflects the past and does not necessarily 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. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for LGI Homes.

Do LGI Homes's Current Liabilities Skew 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.

LGI Homes has total assets of US$1.5b and current liabilities of US$165m. Therefore its current liabilities are equivalent to approximately 11% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.

Our Take On LGI Homes's ROCE

This is good to see, and with a sound ROCE, LGI Homes could be worth a closer look. LGI Homes 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 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 editorial-team@simplywallst.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.