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. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. All else being equal, a better business will have a higher ROCE. 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'.
So, How Do We Calculate ROCE?
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 Parker-Hannifin:
0.14 = US$2.1b ÷ (US$18b - US$3.2b) (Based on the trailing twelve months to June 2019.)
So, Parker-Hannifin has an ROCE of 14%.
Is Parker-Hannifin's ROCE Good?
One way to assess ROCE is to compare similar companies. In our analysis, Parker-Hannifin's ROCE is meaningfully higher than the 11% 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.
You can see in the image below how Parker-Hannifin's ROCE compares to its industry. Click to see more on past growth.
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 only a point-in-time measure. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Do Parker-Hannifin's Current Liabilities Skew 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Parker-Hannifin has total liabilities of US$3.2b and total assets of US$18b. Therefore its current liabilities are equivalent to approximately 18% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.
Our Take On Parker-Hannifin's ROCE
With that in mind, Parker-Hannifin's ROCE appears pretty good. There might be better investments than Parker-Hannifin out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
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