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Why You Should Care About Energy Recovery, Inc.’s (NASDAQ:ERII) Low Return On Capital

Simply Wall St

Today we'll evaluate Energy Recovery, Inc. (NASDAQ:ERII) 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, 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. Generally speaking a higher ROCE is better. 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 Energy Recovery:

0.088 = US$14m ÷ (US$183m - US$24m) (Based on the trailing twelve months to June 2019.)

Therefore, Energy Recovery has an ROCE of 8.8%.

View our latest analysis for Energy Recovery

Is Energy Recovery's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. We can see Energy Recovery's ROCE is meaningfully below the Machinery industry average of 11%. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Separate from how Energy Recovery 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.

Energy Recovery delivered an ROCE of 8.8%, which is better than 3 years ago, as was making losses back then. This makes us wonder if the company is improving. The image below shows how Energy Recovery's ROCE compares to its industry, and you can click it to see more detail on its past growth.

NasdaqGS:ERII Past Revenue and Net Income, September 28th 2019

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. 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 Energy Recovery.

Energy Recovery's Current Liabilities And Their Impact On Its ROCE

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Energy Recovery has total assets of US$183m and current liabilities of US$24m. As a result, its current liabilities are equal to approximately 13% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.

The Bottom Line On Energy Recovery's ROCE

If Energy Recovery continues to earn an uninspiring ROCE, there may be better places to invest. But note: make sure you look for a great company, not just the first idea you come across. 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.