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Shareholders Should Look Hard At Luna Innovations Incorporated’s (NASDAQ:LUNA) 3.1% Return On Capital

Simply Wall St

Today we'll look at Luna Innovations Incorporated (NASDAQ:LUNA) and reflect on its potential as an investment. 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, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. In general, businesses with a higher ROCE are usually better quality. 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.'

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 Luna Innovations:

0.031 = US$2.1m ÷ (US$84m - US$17m) (Based on the trailing twelve months to March 2019.)

So, Luna Innovations has an ROCE of 3.1%.

Check out our latest analysis for Luna Innovations

Does Luna Innovations Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. We can see Luna Innovations's ROCE is meaningfully below the Electronic industry average of 12%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Regardless of how Luna Innovations stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). Readers may wish to look for more rewarding investments.

Luna Innovations has an ROCE of 3.1%, but it didn't have an ROCE 3 years ago, since it was unprofitable. This makes us wonder if the company is improving. The image below shows how Luna Innovations's ROCE compares to its industry, and you can click it to see more detail on its past growth.

NasdaqCM:LUNA Past Revenue and Net Income, August 15th 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.

What Are Current Liabilities, And How Do They Affect Luna Innovations's ROCE?

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Luna Innovations has total assets of US$84m and current liabilities of US$17m. Therefore its current liabilities are equivalent to approximately 20% of its total assets. This is a modest level of current liabilities, which will have a limited impact on the ROCE.

Our Take On Luna Innovations's ROCE

While that is good to see, Luna Innovations has a low ROCE and does not look attractive in this analysis. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

I will like Luna Innovations better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

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.