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Here’s What SDL plc’s (LON:SDL) Return On Capital Can Tell Us

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Today we are going to look at SDL plc (LON:SDL) to see whether it might be an attractive investment prospect. To be precise, we’ll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

First up, we’ll look at what ROCE is and how we calculate it. Next, we’ll compare it to others in its industry. Then we’ll determine how its current liabilities are affecting its ROCE.

What is 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. 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 SDL:

0.12 = UK£19m ÷ (UK£295m – UK£95m) (Based on the trailing twelve months to June 2018.)

Therefore, SDL has an ROCE of 12%.

See our latest analysis for SDL

Is SDL’s ROCE Good?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, SDL’s ROCE appears to be around the 12% average of the Software industry. Regardless of where SDL sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.

As we can see, SDL currently has an ROCE of 12% compared to its ROCE 3 years ago, which was 6.7%. This makes us think about whether the company has been reinvesting shrewdly.

LSE:SDL Last Perf February 4th 19
LSE:SDL Last Perf February 4th 19

When considering this metric, keep in mind that it is backwards looking, and 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Since the future is so important for investors, you should check out our free report on analyst forecasts for SDL.

SDL’s Current Liabilities And Their Impact On Its ROCE

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.

SDL has total assets of UK£295m and current liabilities of UK£95m. As a result, its current liabilities are equal to approximately 32% of its total assets. SDL has a middling amount of current liabilities, increasing its ROCE somewhat.

What We Can Learn From SDL’s ROCE

With a decent ROCE, the company could be interesting, but remember that the level of current liabilities make the ROCE look better. You might be able to find a better buy than SDL. 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 SDL 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 editorial-team@simplywallst.com.

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