Today we'll look at Tower Semiconductor Ltd. (NASDAQ:TSEM) and reflect on its potential as an investment. 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 up, we'll look at what ROCE is and how we calculate it. Second, we'll look at its ROCE compared to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
Return On Capital Employed (ROCE): What is it?
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. 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'.
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 Tower Semiconductor:
0.075 = US$124m ÷ (US$1.9b - US$212m) (Based on the trailing twelve months to June 2019.)
So, Tower Semiconductor has an ROCE of 7.5%.
Is Tower Semiconductor's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. We can see Tower Semiconductor's ROCE is meaningfully below the Semiconductor industry average of 10%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Separate from how Tower Semiconductor stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Readers may find more attractive investment prospects elsewhere.
Tower Semiconductor's current ROCE of 7.5% is lower than 3 years ago, when the company reported a 12% ROCE. This makes us wonder if the business is facing new challenges. You can click on the image below to see (in greater detail) how Tower Semiconductor's past growth compares to other companies.
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. 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 Tower Semiconductor.
How Tower Semiconductor'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. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Tower Semiconductor has total liabilities of US$212m and total assets of US$1.9b. Therefore its current liabilities are equivalent to approximately 11% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.
The Bottom Line On Tower Semiconductor's ROCE
That said, Tower Semiconductor's ROCE is mediocre, there may be more attractive investments around. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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