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Is There More To Severn Trent Plc (LON:SVT) Than Its 6.1%Returns On Capital?

Kari Hurd

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Today we’ll evaluate Severn Trent Plc (LON:SVT) 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, we’ll go over how we calculate ROCE. Then we’ll compare its ROCE to similar companies. Then we’ll determine how its current liabilities are affecting 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. All else being equal, a better business will have a higher ROCE. 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?

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 Severn Trent:

0.061 = UK£519m ÷ (UK£9.8b – UK£985m) (Based on the trailing twelve months to September 2018.)

So, Severn Trent has an ROCE of 6.1%.

See our latest analysis for Severn Trent

Does Severn Trent Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. It appears that Severn Trent’s ROCE is fairly close to the Water Utilities industry average of 6.1%. Aside from the industry comparison, Severn Trent’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.

LSE:SVT Last Perf February 4th 19

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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

Severn Trent’s Current Liabilities And Their Impact On 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.

Severn Trent has total liabilities of UK£985m and total assets of UK£9.8b. As a result, its current liabilities are equal to approximately 10% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.

What We Can Learn From Severn Trent’s ROCE

With that in mind, we’re not overly impressed with Severn Trent’s ROCE, so it may not be the most appealing prospect. 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.

If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.