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Here’s why Arconic Inc.’s (NYSE:ARNC) Returns On Capital Matters So Much

Simply Wall St

Today we’ll evaluate Arconic Inc. (NYSE:ARNC) 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 up, we’ll look at what ROCE is and how we calculate it. Second, we’ll look at its ROCE compared to similar companies. Then we’ll determine how its current liabilities are affecting 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. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.’

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 Arconic:

0.081 = US$1.2b ÷ (US$19b – US$3.5b) (Based on the trailing twelve months to December 2018.)

Therefore, Arconic has an ROCE of 8.1%.

Check out our latest analysis for Arconic

Does Arconic Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. We can see Arconic’s ROCE is meaningfully below the Aerospace & Defense industry average of 11%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Separate from how Arconic stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. It is possible that there are more rewarding investments out there.

As we can see, Arconic currently has an ROCE of 8.1% compared to its ROCE 3 years ago, which was 2.9%. This makes us think about whether the company has been reinvesting shrewdly.

NYSE:ARNC Past Revenue and Net Income, February 28th 2019

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. 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 Arconic.

Do Arconic’s Current Liabilities Skew Its ROCE?

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.

Arconic has total liabilities of US$3.5b and total assets of US$19b. As a result, its current liabilities are equal to approximately 19% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.

Our Take On Arconic’s ROCE

If Arconic continues to earn an uninspiring ROCE, there may be better places to invest. But note: Arconic may not be the best stock to buy. 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 editorial-team@simplywallst.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.