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Should You Like A. O. Smith Corporation’s (NYSE:AOS) High Return On Capital Employed?

Simply Wall St

Today we'll evaluate A. O. Smith Corporation (NYSE:AOS) to determine whether it could have potential as an investment idea. 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 up, we'll look at what ROCE is and how we calculate it. 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 metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. In brief, it is a useful tool, but it is not without drawbacks. 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 A. O. Smith:

0.22 = US$528m ÷ (US$3.2b - US$731m) (Based on the trailing twelve months to June 2019.)

Therefore, A. O. Smith has an ROCE of 22%.

See our latest analysis for A. O. Smith

Does A. O. Smith Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. In our analysis, A. O. Smith's ROCE is meaningfully higher than the 12% average in the Building 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, A. O. Smith's ROCE is currently very good.

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

NYSE:AOS Past Revenue and Net Income, September 17th 2019

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is, after all, simply a snap shot of a single year. Since the future is so important for investors, you should check out our free report on analyst forecasts for A. O. Smith.

What Are Current Liabilities, And How Do They Affect A. O. Smith's ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. 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.

A. O. Smith has total liabilities of US$731m and total assets of US$3.2b. Therefore its current liabilities are equivalent to approximately 23% of its total assets. A minimal amount of current liabilities limits the impact on ROCE.

What We Can Learn From A. O. Smith's ROCE

With low current liabilities and a high ROCE, A. O. Smith could be worthy of further investigation. A. O. Smith looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.

I will like A. O. Smith better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

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.