Today we'll evaluate Wesfarmers Limited (ASX:WES) 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. Then we'll compare its ROCE to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
What is 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. 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 Wesfarmers:
0.19 = AU$2.5b ÷ (AU$18b - AU$5.2b) (Based on the trailing twelve months to June 2019.)
Therefore, Wesfarmers has an ROCE of 19%.
Is Wesfarmers's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that Wesfarmers's ROCE is meaningfully better than the 8.1% average in the Multiline Retail industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Independently of how Wesfarmers compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
Our data shows that Wesfarmers currently has an ROCE of 19%, compared to its ROCE of 10% 3 years ago. This makes us wonder if the company is improving. You can click on the image below to see (in greater detail) how Wesfarmers'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. ROCE is, after all, simply a snap shot of a single year. Since the future is so important for investors, you should check out our free report on analyst forecasts for Wesfarmers.
Do Wesfarmers'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 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Wesfarmers has total assets of AU$18b and current liabilities of AU$5.2b. Therefore its current liabilities are equivalent to approximately 28% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
The Bottom Line On Wesfarmers's ROCE
Overall, Wesfarmers has a decent ROCE and could be worthy of further research. There might be better investments than Wesfarmers out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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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.