Today we are going to look at BHP Group (ASX:BHP) to see whether it might be an attractive investment prospect. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. All else being equal, a better business will have a higher ROCE. Ultimately, it is a useful but imperfect metric. 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 BHP Group:
0.17 = US$16b ÷ (US$102b - US$10b) (Based on the trailing twelve months to December 2018.)
Therefore, BHP Group has an ROCE of 17%.
Does BHP Group Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. BHP Group's ROCE appears to be substantially greater than the 9.5% average in the Metals and Mining industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Separate from BHP Group's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
In our analysis, BHP Group's ROCE appears to be 17%, compared to 3 years ago, when its ROCE was 4.1%. This makes us wonder if the company is improving. You can click on the image below to see (in greater detail) how BHP Group'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 misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. We note BHP Group could be considered a cyclical business. Since the future is so important for investors, you should check out our free report on analyst forecasts for BHP Group.
BHP Group's Current Liabilities And Their Impact On Its ROCE
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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.
BHP Group has total assets of US$102b and current liabilities of US$10b. Therefore its current liabilities are equivalent to approximately 10% of its total assets. Low current liabilities are not boosting the ROCE too much.
The Bottom Line On BHP Group's ROCE
This is good to see, and with a sound ROCE, BHP Group could be worth a closer look. There might be better investments than BHP Group 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.
I will like BHP Group better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider 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.