Today we'll look at Cervantes Corporation Limited (ASX:CVS) and reflect on its potential as an investment. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE 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. 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'.
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 Cervantes:
0.041 = AU$27k ÷ (AU$1.9m - AU$1.2m) (Based on the trailing twelve months to December 2018.)
Therefore, Cervantes has an ROCE of 4.1%.
Is Cervantes's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. We can see Cervantes's ROCE is meaningfully below the Metals and Mining industry average of 9.5%. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Putting aside Cervantes's performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. It is likely that there are more attractive prospects out there.
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. Remember that most companies like Cervantes are cyclical businesses. You can check if Cervantes has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
How Cervantes's Current Liabilities Impact 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.
Cervantes has total liabilities of AU$1.2m and total assets of AU$1.9m. Therefore its current liabilities are equivalent to approximately 65% of its total assets. Current liabilities of this level result in a meaningful boost to Cervantes's ROCE.
What We Can Learn From Cervantes's ROCE
Unfortunately, its ROCE is also pretty low, so we are cautious about the stock. You might be able to find a better investment than Cervantes. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
I will like Cervantes 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.