Today we are going to look at Lumentum Holdings Inc. (NASDAQ:LITE) to see whether it might be an attractive investment prospect. 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.
Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. 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?
Analysts use this formula to calculate return on capital employed:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
Or for Lumentum Holdings:
0.064 = US$158m ÷ (US$2.8b - US$326m) (Based on the trailing twelve months to December 2018.)
Therefore, Lumentum Holdings has an ROCE of 6.4%.
Is Lumentum Holdings's ROCE Good?
One way to assess ROCE is to compare similar companies. In this analysis, Lumentum Holdings's ROCE appears meaningfully below the 8.4% average reported by the Communications industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Separate from how Lumentum Holdings stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. It is possible that there are more rewarding investments out there.
Lumentum Holdings has an ROCE of 6.4%, but it didn't have an ROCE 3 years ago, since it was unprofitable. This makes us wonder if the company is improving.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. 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 Lumentum Holdings.
What Are Current Liabilities, And How Do They Affect Lumentum Holdings's ROCE?
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Lumentum Holdings has total liabilities of US$326m and total assets of US$2.8b. As a result, its current liabilities are equal to approximately 12% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.
Our Take On Lumentum Holdings's ROCE
If Lumentum Holdings continues to earn an uninspiring ROCE, there may be better places to invest. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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.