Southwest Airlines Co. (NYSE:LUV) Earns A Nice Return On Capital Employed
Today we’ll evaluate Southwest Airlines Co. (NYSE:LUV) 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 of all, we’ll work out how to calculate ROCE. Second, we’ll look at its ROCE compared 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 ‘return’ (pre-tax profit) a company generates from 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’.
How Do You Calculate Return On Capital Employed?
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 Southwest Airlines:
0.17 = US$3.5b ÷ (US$27b – US$7.8b) (Based on the trailing twelve months to September 2018.)
Therefore, Southwest Airlines has an ROCE of 17%.
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Does Southwest Airlines Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. Using our data, we find that Southwest Airlines’s ROCE is meaningfully better than the 11% average in the Airlines industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Separate from Southwest Airlines’s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
Southwest Airlines’s current ROCE of 17% is lower than 3 years ago, when the company reported a 26% ROCE. Therefore we wonder if the company is facing new headwinds.
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. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Southwest Airlines.
Do Southwest Airlines’s Current Liabilities Skew Its ROCE?
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Southwest Airlines has total assets of US$27b and current liabilities of US$7.8b. Therefore its current liabilities are equivalent to approximately 29% of its total assets. Low current liabilities are not boosting the ROCE too much.
The Bottom Line On Southwest Airlines’s ROCE
With that in mind, Southwest Airlines’s ROCE appears pretty good. But note: Southwest Airlines may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.
