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Slater and Gordon Limited’s (ASX:SGH) Investment Returns Are Lagging Its Industry

Simply Wall St

Today we'll evaluate Slater and Gordon Limited (ASX:SGH) 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.

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. All else being equal, a better business will have a higher ROCE. 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 Slater and Gordon:

0.046 = AU$12m ÷ (AU$339m - AU$81m) (Based on the trailing twelve months to June 2019.)

So, Slater and Gordon has an ROCE of 4.6%.

See our latest analysis for Slater and Gordon

Does Slater and Gordon Have A Good ROCE?

One way to assess ROCE is to compare similar companies. We can see Slater and Gordon's ROCE is meaningfully below the Consumer Services industry average of 9.2%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Putting aside Slater and Gordon's performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. Readers may wish to look for more rewarding investments.

Slater and Gordon reported an ROCE of 4.6% -- better than 3 years ago, when the company didn't make a profit. This makes us wonder if the company is improving. You can click on the image below to see (in greater detail) how Slater and Gordon's past growth compares to other companies.

ASX:SGH Past Revenue and Net Income, November 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. How cyclical is Slater and Gordon? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

Do Slater and Gordon's Current Liabilities Skew 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. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Slater and Gordon has total assets of AU$339m and current liabilities of AU$81m. Therefore its current liabilities are equivalent to approximately 24% of its total assets. With a very reasonable level of current liabilities, so the impact on ROCE is fairly minimal.

The Bottom Line On Slater and Gordon's ROCE

That's not a bad thing, however Slater and Gordon has a weak ROCE and may not be an attractive investment. 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).

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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.

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. Thank you for reading.