Today we’ll evaluate Parker-Hannifin Corporation (NYSE:PH) 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. Finally, we’ll look at how its current liabilities affect its ROCE.
Understanding 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. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.’
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 Parker-Hannifin:
0.17 = US$2.0b ÷ (US$15b – US$3.3b) (Based on the trailing twelve months to September 2018.)
So, Parker-Hannifin has an ROCE of 17%.
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Does Parker-Hannifin Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. In our analysis, Parker-Hannifin’s ROCE is meaningfully higher than the 12% average in the Machinery 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. Independently of how Parker-Hannifin compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
It is important to remember that ROCE shows past performance, and is 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Parker-Hannifin.
How Parker-Hannifin’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 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Parker-Hannifin has total assets of US$15b and current liabilities of US$3.3b. As a result, its current liabilities are equal to approximately 21% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.
What We Can Learn From Parker-Hannifin’s ROCE
This is good to see, and with a sound ROCE, Parker-Hannifin could be worth a closer look. 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 like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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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 email@example.com.