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Sims Metal Management Limited’s (ASX:SGM) Investment Returns Are Lagging Its Industry

Simply Wall St

Today we are going to look at Sims Metal Management Limited (ASX:SGM) 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. Then we'll compare its ROCE to similar companies. Finally, we'll look at how its current liabilities affect its ROCE.

Return On Capital Employed (ROCE): What is it?

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. Ultimately, it is a useful but imperfect metric. 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'.

So, How Do We Calculate ROCE?

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 Sims Metal Management:

0.058 = AU$146m ÷ (AU$3.2b - AU$659m) (Based on the trailing twelve months to June 2019.)

Therefore, Sims Metal Management has an ROCE of 5.8%.

Check out our latest analysis for Sims Metal Management

Is Sims Metal Management's ROCE Good?

ROCE is commonly used for comparing the performance of similar businesses. We can see Sims Metal Management's ROCE is meaningfully below the Metals and Mining industry average of 7.9%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Aside from the industry comparison, Sims Metal Management's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.

Sims Metal Management has an ROCE of 5.8%, but it didn't have an ROCE 3 years ago, since it was unprofitable. That suggests the business has returned to profitability. You can click on the image below to see (in greater detail) how Sims Metal Management's past growth compares to other companies.

ASX:SGM Past Revenue and Net Income, October 22nd 2019

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. We note Sims Metal Management could be considered a cyclical business. Since the future is so important for investors, you should check out our free report on analyst forecasts for Sims Metal Management.

How Sims Metal Management's Current Liabilities Impact Its ROCE

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Sims Metal Management has total liabilities of AU$659m and total assets of AU$3.2b. As a result, its current liabilities are equal to approximately 21% of its total assets. It is good to see a restrained amount of current liabilities, as this limits the effect on ROCE.

What We Can Learn From Sims Metal Management's ROCE

If Sims Metal Management continues to earn an uninspiring ROCE, there may be better places to invest. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

If you are like me, then you will not want to miss this free list of growing companies that insiders are 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.