Today we'll evaluate TORM plc (CPH:TRMD A) to determine whether it could have potential as an investment idea. Specifically, we'll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.
Firstly, we'll go over how we 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.
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. All else being equal, a better business will have a higher ROCE. In brief, it is a useful tool, but it is not without drawbacks. 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 TORM:
0.029 = US$45m ÷ (US$1.7b - US$174m) (Based on the trailing twelve months to June 2019.)
So, TORM has an ROCE of 2.9%.
Is TORM's ROCE Good?
One way to assess ROCE is to compare similar companies. Using our data, TORM's ROCE appears to be significantly below the 10% average in the Oil and Gas industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Putting aside TORM's performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. There are potentially more appealing investments elsewhere.
TORM's current ROCE of 2.9% is lower than its ROCE in the past, which was 10%, 3 years ago. Therefore we wonder if the company is facing new headwinds. You can see in the image below how TORM's ROCE compares to its industry. Click to see more on past growth.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is, after all, simply a snap shot of a single year. Given the industry it operates in, TORM could be considered cyclical. Since the future is so important for investors, you should check out our free report on analyst forecasts for TORM.
Do TORM's Current Liabilities Skew 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 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
TORM has total liabilities of US$174m and total assets of US$1.7b. As a result, its current liabilities are equal to approximately 10% of its total assets. With a very reasonable level of current liabilities, so the impact on ROCE is fairly minimal.
What We Can Learn From TORM's ROCE
That's not a bad thing, however TORM 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).
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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 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. Thank you for reading.