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Is National Grid plc's (LON:NG.) Capital Allocation Ability Worth Your Time?

Simply Wall St

Today we are going to look at National Grid plc (LON:NG.) 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. 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 measures the amount of pre-tax profits a company can generate from the capital employed in its business. In general, businesses with a higher ROCE are usually better quality. 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?

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 National Grid:

0.059 = UK£3.4b ÷ (UK£66b - UK£9.5b) (Based on the trailing twelve months to September 2019.)

So, National Grid has an ROCE of 5.9%.

Check out our latest analysis for National Grid

Does National Grid Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, National Grid's ROCE appears to be around the 5.2% average of the Integrated Utilities industry. Aside from the industry comparison, National Grid's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.

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

LSE:NG. Past Revenue and Net Income, December 4th 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. Since the future is so important for investors, you should check out our free report on analyst forecasts for National Grid.

How National Grid's Current Liabilities Impact Its ROCE

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

National Grid has total liabilities of UK£9.5b and total assets of UK£66b. As a result, its current liabilities are equal to approximately 14% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.

The Bottom Line On National Grid's ROCE

With that in mind, we're not overly impressed with National Grid's ROCE, so it may not be the most appealing prospect. Of course, you might also be able to find a better stock than National Grid. So you may wish to see this free collection of other companies that have grown earnings strongly.

If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).

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.

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. Thank you for reading.