Today we'll evaluate Signify N.V. (AMS:LIGHT) to determine whether it could have potential as an investment idea. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested 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.
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 Signify:
0.13 = €542m ÷ (€6.4b - €2.1b) (Based on the trailing twelve months to June 2019.)
Therefore, Signify has an ROCE of 13%.
Is Signify's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. It appears that Signify's ROCE is fairly close to the Electrical industry average of 11%. Separate from Signify's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
In our analysis, Signify's ROCE appears to be 13%, compared to 3 years ago, when its ROCE was 8.3%. This makes us think the business might be improving. You can see in the image below how Signify's ROCE compares to its industry. Click to see more on past growth.
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 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. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Signify.
How Signify'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 the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Signify has total assets of €6.4b and current liabilities of €2.1b. As a result, its current liabilities are equal to approximately 33% of its total assets. Signify has a medium level of current liabilities, which would boost the ROCE.
The Bottom Line On Signify's ROCE
While its ROCE looks good, it's worth remembering that the current liabilities are making the business look better. There might be better investments than Signify out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
I will like Signify 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 firstname.lastname@example.org. 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.