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Are Praemium Limited’s (ASX:PPS) High Returns Really That Great?

Simply Wall St

Today we are going to look at Praemium Limited (ASX:PPS) to see whether it might be an attractive investment prospect. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First of all, we'll work out how to calculate ROCE. Second, we'll look at its ROCE compared to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Generally speaking a higher ROCE is better. Ultimately, it is a useful but imperfect metric. 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 Praemium:

0.32 = AU$6.7m ÷ (AU$32m - AU$11m) (Based on the trailing twelve months to December 2018.)

So, Praemium has an ROCE of 32%.

View our latest analysis for Praemium

Is Praemium's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. Using our data, we find that Praemium's ROCE is meaningfully better than the 19% average in the Software industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Regardless of the industry comparison, in absolute terms, Praemium's ROCE currently appears to be excellent.

We can see that , Praemium currently has an ROCE of 32% compared to its ROCE 3 years ago, which was 13%. This makes us think the business might be improving. You can see in the image below how Praemium's ROCE compares to its industry. Click to see more on past growth.

ASX:PPS Past Revenue and Net Income, July 22nd 2019

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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 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 Praemium's Current Liabilities Skew Its ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counter this, investors can check if a company has high current liabilities relative to total assets.

Praemium has total liabilities of AU$11m and total assets of AU$32m. Therefore its current liabilities are equivalent to approximately 35% of its total assets. Praemium's ROCE is boosted somewhat by its middling amount of current liabilities.

The Bottom Line On Praemium's ROCE

Still, it has a high ROCE, and may be an interesting prospect for further research. Praemium 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.

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 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.