Today we are going to look at Tesco PLC (LON:TSCO) 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.
Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested 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 Tesco:
0.074 = UK£2.1b ÷ (UK£49b - UK£21b) (Based on the trailing twelve months to February 2019.)
Therefore, Tesco has an ROCE of 7.4%.
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Does Tesco Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. We can see Tesco's ROCE is around the 7.4% average reported by the Consumer Retailing industry. Aside from the industry comparison, Tesco's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.
In our analysis, Tesco's ROCE appears to be 7.4%, compared to 3 years ago, when its ROCE was 3.0%. This makes us think the business might be improving.
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 deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is only a point-in-time measure. Since the future is so important for investors, you should check out our free report on analyst forecasts for Tesco.
How Tesco'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 counter this, investors can check if a company has high current liabilities relative to total assets.
Tesco has total liabilities of UK£21b and total assets of UK£49b. Therefore its current liabilities are equivalent to approximately 42% of its total assets. Tesco's ROCE is improved somewhat by its moderate amount of current liabilities.
The Bottom Line On Tesco's ROCE
Unfortunately, its ROCE is still uninspiring, and there are potentially more attractive prospects out there. 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).
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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 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.