Today we'll evaluate Arista Networks, Inc. (NYSE:ANET) 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.
First, we'll go over how we calculate ROCE. 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.
Understanding 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. 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'.
So, How Do We Calculate ROCE?
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 Arista Networks:
0.27 = US$827m ÷ (US$3.6b - US$548m) (Based on the trailing twelve months to September 2019.)
So, Arista Networks has an ROCE of 27%.
Does Arista Networks Have A Good ROCE?
One way to assess ROCE is to compare similar companies. Arista Networks's ROCE appears to be substantially greater than the 6.9% average in the Communications industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Setting aside the comparison to its industry for a moment, Arista Networks's ROCE in absolute terms currently looks quite high.
We can see that, Arista Networks currently has an ROCE of 27% compared to its ROCE 3 years ago, which was 18%. This makes us think the business might be improving. The image below shows how Arista Networks's ROCE compares to its industry, and you can click it to see more detail on its past growth.
It is important to remember that ROCE shows past performance, and is 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. ROCE is, after all, simply a snap shot of a single year. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
What Are Current Liabilities, And How Do They Affect Arista Networks's ROCE?
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counter this, investors can check if a company has high current liabilities relative to total assets.
Arista Networks has total assets of US$3.6b and current liabilities of US$548m. As a result, its current liabilities are equal to approximately 15% of its total assets. The fairly low level of current liabilities won't have much impact on the already great ROCE.
The Bottom Line On Arista Networks's ROCE
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