U.S. Markets closed

Are Lycopodium Limited’s (ASX:LYL) High Returns Really That Great?

Simply Wall St

Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!

Today we are going to look at Lycopodium Limited (ASX:LYL) 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, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Finally, we'll look at how its current liabilities affect 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. In general, businesses with a higher ROCE are usually better quality. Ultimately, it is a useful but imperfect metric. 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?

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 Lycopodium:

0.38 = AU$29m ÷ (AU$116m - AU$39m) (Based on the trailing twelve months to December 2018.)

So, Lycopodium has an ROCE of 38%.

Check out our latest analysis for Lycopodium

Does Lycopodium Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. Using our data, we find that Lycopodium's ROCE is meaningfully better than the 20% average in the Construction 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. Putting aside its position relative to its industry for now, in absolute terms, Lycopodium's ROCE is currently very good.

Lycopodium reported an ROCE of 38% -- better than 3 years ago, when the company didn't make a profit. This makes us wonder if the company is improving. You can see in the image below how Lycopodium's ROCE compares to its industry. Click to see more on past growth.

ASX:LYL Past Revenue and Net Income, July 16th 2019

It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is only a point-in-time measure. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

Do Lycopodium'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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Lycopodium has total assets of AU$116m and current liabilities of AU$39m. As a result, its current liabilities are equal to approximately 33% of its total assets. A medium level of current liabilities boosts Lycopodium's ROCE somewhat.

The Bottom Line On Lycopodium's ROCE

Even so, it has a great ROCE, and could be an attractive prospect for further research. There might be better investments than Lycopodium out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.

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 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.