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Today we are going to look at Sims Metal Management Limited (ASX:SGM) to see whether it might be an attractive investment prospect. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First up, we'll look at what ROCE is and how we calculate it. 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 measures the amount of pre-tax profits a company can generate from the capital employed in its business. In general, businesses with a higher ROCE are usually better quality. 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 Sims Metal Management:
0.064 = AU$160m ÷ (AU$3.1b - AU$627m) (Based on the trailing twelve months to December 2018.)
So, Sims Metal Management has an ROCE of 6.4%.
Does Sims Metal Management Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. We can see Sims Metal Management's ROCE is meaningfully below the Metals and Mining industry average of 8.3%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Aside from the industry comparison, Sims Metal Management's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Readers may find more attractive investment prospects elsewhere.
Sims Metal Management has an ROCE of 6.4%, but it didn't have an ROCE 3 years ago, since it was unprofitable. That implies the business has been improving.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is, after all, simply a snap shot of a single year. We note Sims Metal Management could be considered a cyclical business. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Sims Metal Management.
How Sims Metal Management'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 the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counteract this, we check if a company has high current liabilities, relative to its total assets.
Sims Metal Management has total liabilities of AU$627m and total assets of AU$3.1b. As a result, its current liabilities are equal to approximately 20% of its total assets. It is good to see a restrained amount of current liabilities, as this limits the effect on ROCE.
What We Can Learn From Sims Metal Management's ROCE
If Sims Metal Management continues to earn an uninspiring ROCE, there may be better places to invest. Of course you might be able to find a better stock than Sims Metal Management. So you may wish to see this free collection of other companies that have grown earnings strongly.
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 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.