Today we'll evaluate Spirent Communications plc (LON:SPT) 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. Then we'll compare its ROCE to similar companies. Finally, we'll look at how its current liabilities affect its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. 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?
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 Spirent Communications:
0.18 = US$70m ÷ (US$535m - US$134m) (Based on the trailing twelve months to June 2019.)
So, Spirent Communications has an ROCE of 18%.
Is Spirent Communications's ROCE Good?
One way to assess ROCE is to compare similar companies. In our analysis, Spirent Communications's ROCE is meaningfully higher than the 11% average in the Communications industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Independently of how Spirent Communications compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
In our analysis, Spirent Communications's ROCE appears to be 18%, compared to 3 years ago, when its ROCE was 7.0%. This makes us think the business might be improving. The image below shows how Spirent Communications's ROCE compares to its industry, and you can click it to see more detail on its past growth.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
How Spirent Communications'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. 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.
Spirent Communications has total liabilities of US$134m and total assets of US$535m. As a result, its current liabilities are equal to approximately 25% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.
The Bottom Line On Spirent Communications's ROCE
This is good to see, and with a sound ROCE, Spirent Communications could be worth a closer look. Spirent Communications looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.
I will like Spirent Communications better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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.
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