Today we’ll evaluate Power Integrations, Inc. (NASDAQ:POWI) 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.
Firstly, we’ll go over how we calculate ROCE. Next, we’ll compare it to others in its industry. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the 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. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.’
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 Power Integrations:
0.10 = US$56m ÷ (US$589m – US$48m) (Based on the trailing twelve months to December 2018.)
Therefore, Power Integrations has an ROCE of 10%.
Does Power Integrations Have A Good ROCE?
One way to assess ROCE is to compare similar companies. We can see Power Integrations’s ROCE is meaningfully below the Semiconductor industry average of 14%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Separate from how Power Integrations stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Readers may find more attractive investment prospects elsewhere.
Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately 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, after all, simply a snap shot of a single year. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Power Integrations.
What Are Current Liabilities, And How Do They Affect Power Integrations’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 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.
Power Integrations has total liabilities of US$48m and total assets of US$589m. As a result, its current liabilities are equal to approximately 8.2% of its total assets. Power Integrations reports few current liabilities, which have a negligible impact on its unremarkable ROCE.
Our Take On Power Integrations’s ROCE
If performance improves, then Power Integrations may be an OK investment, especially at the right valuation. But note: Power Integrations may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio 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).
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 email@example.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.