Today we'll look at The Southern Company (NYSE:SO) and reflect on its potential as an investment. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.
First, 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.
What is Return On Capital Employed (ROCE)?
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. Overall, it is a valuable metric that has its flaws. 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 Southern:
0.049 = US$5.0b ÷ (US$115b - US$11b) (Based on the trailing twelve months to June 2019.)
So, Southern has an ROCE of 4.9%.
Is Southern's ROCE Good?
One way to assess ROCE is to compare similar companies. It appears that Southern's ROCE is fairly close to the Electric Utilities industry average of 4.9%. Independently of how Southern compares to its industry, its ROCE in absolute terms is low; especially compared to the ~2.7% available in government bonds. There are potentially more appealing investments elsewhere.
You can see in the image below how Southern'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, after all, simply a snap shot of a single year. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Southern.
How Southern'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 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.
Southern has total assets of US$115b and current liabilities of US$11b. As a result, its current liabilities are equal to approximately 9.6% of its total assets. With barely any current liabilities, there is minimal impact on Southern's admittedly low ROCE.
What We Can Learn From Southern's ROCE
Still, investors could probably find more attractive prospects with better performance out there. You might be able to find a better investment than Southern. 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 Southern better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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If you spot an error that warrants correction, please contact the editor at email@example.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.