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Are Nathan's Famous, Inc.’s (NASDAQ:NATH) High Returns Really That Great?

Simply Wall St

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Today we'll evaluate Nathan's Famous, Inc. (NASDAQ:NATH) 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 up, we'll look at what ROCE is and how we calculate it. 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 metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested 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?

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 Nathan's Famous:

0.35 = US$28m ÷ (US$94m - US$15m) (Based on the trailing twelve months to March 2019.)

So, Nathan's Famous has an ROCE of 35%.

Check out our latest analysis for Nathan's Famous

Does Nathan's Famous Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that Nathan's Famous's ROCE is meaningfully better than the 9.4% average in the Hospitality industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Putting aside its position relative to its industry for now, in absolute terms, Nathan's Famous's ROCE is currently very good.

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

NasdaqGS:NATH Past Revenue and Net Income, July 9th 2019

It is important to remember that ROCE shows past performance, and is not necessarily predictive. 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 only a point-in-time measure. You can check if Nathan's Famous has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.

How Nathan's Famous's Current Liabilities Impact Its ROCE

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Nathan's Famous has total assets of US$94m and current liabilities of US$15m. As a result, its current liabilities are equal to approximately 16% of its total assets. The fairly low level of current liabilities won't have much impact on the already great ROCE.

What We Can Learn From Nathan's Famous's ROCE

With low current liabilities and a high ROCE, Nathan's Famous could be worthy of further investigation. Nathan's Famous 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 like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).

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.