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Today we’ll look at Pennon Group Plc (LON:PNN) and reflect on its potential as an investment. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
Firstly, we’ll go over how we calculate ROCE. 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 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. 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 Pennon Group:
0.059 = UK£323m ÷ (UK£6.2b – UK£499m) (Based on the trailing twelve months to September 2018.)
So, Pennon Group has an ROCE of 5.9%.
Does Pennon Group Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. Using our data, Pennon Group’s ROCE appears to be around the 6.1% average of the Water Utilities industry. Separate from how Pennon Group stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Investors may wish to consider higher-performing investments.
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, after all, simply a snap shot of a single year. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
How Pennon Group’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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Pennon Group has total liabilities of UK£499m and total assets of UK£6.2b. Therefore its current liabilities are equivalent to approximately 8.1% of its total assets. Pennon Group reports few current liabilities, which have a negligible impact on its unremarkable ROCE.
The Bottom Line On Pennon Group’s ROCE
Based on this information, Pennon Group appears to be a mediocre business. You might be able to find a better buy than Pennon Group. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
I will like Pennon Group better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
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 firstname.lastname@example.org.