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Why We’re Not Impressed By AGL Energy Limited’s (ASX:AGL) 13% ROCE

Vernon Smith

Today we’ll evaluate AGL Energy Limited (ASX:AGL) 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. 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.

Return On Capital Employed (ROCE): What is it?

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. In brief, it is a useful tool, but it is not without drawbacks. 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?

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 AGL Energy:

0.13 = AU$1.6b ÷ (AU$15b – AU$2.3b) (Based on the trailing twelve months to June 2018.)

So, AGL Energy has an ROCE of 13%.

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Does AGL Energy Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. Using our data, we find that AGL Energy’s ROCE is meaningfully better than the 6.0% average in the Integrated Utilities industry. I think that’s good to see, since it implies the company is better than other companies at making the most of its capital. Separate from AGL Energy’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, AGL Energy’s ROCE appears to be 13%, compared to 3 years ago, when its ROCE was 6.3%. This makes us think about whether the company has been reinvesting shrewdly.

ASX:AGL Last Perf January 19th 19

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 only a point-in-time measure. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

AGL Energy’s Current Liabilities And Their Impact On Its ROCE

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

AGL Energy has total liabilities of AU$2.3b and total assets of AU$15b. Therefore its current liabilities are equivalent to approximately 16% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.

The Bottom Line On AGL Energy’s ROCE

With that in mind, AGL Energy’s ROCE appears pretty good. Of course you might be able to find a better stock than AGL Energy. So you may wish to see this free collection of other companies that have grown earnings strongly.

I will like AGL Energy better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.