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Why We’re Not Keen On CarMax, Inc.’s (NYSE:KMX) 6.6% Return On Capital

Simply Wall St

Today we'll look at CarMax, Inc. (NYSE:KMX) and reflect on its potential as an investment. 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 up, we'll look at what ROCE is and how we calculate it. Second, we'll look at its ROCE compared to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. In general, businesses with a higher ROCE are usually better quality. 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 CarMax:

0.066 = US$1.2b ÷ (US$20b - US$1.4b) (Based on the trailing twelve months to August 2019.)

So, CarMax has an ROCE of 6.6%.

See our latest analysis for CarMax

Is CarMax's ROCE Good?

One way to assess ROCE is to compare similar companies. In this analysis, CarMax's ROCE appears meaningfully below the 10% average reported by the Specialty Retail industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Aside from the industry comparison, CarMax's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.

You can click on the image below to see (in greater detail) how CarMax's past growth compares to other companies.

NYSE:KMX Past Revenue and Net Income, October 1st 2019

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is only a point-in-time measure. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for CarMax.

What Are Current Liabilities, And How Do They Affect CarMax's ROCE?

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. 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 counter this, investors can check if a company has high current liabilities relative to total assets.

CarMax has total assets of US$20b and current liabilities of US$1.4b. As a result, its current liabilities are equal to approximately 6.9% of its total assets. With low levels of current liabilities, at least CarMax's mediocre ROCE is not unduly boosted.

What We Can Learn From CarMax's ROCE

If performance improves, then CarMax may be an OK investment, especially at the right valuation. Of course, you might also be able to find a better stock than CarMax. So you may wish to see this free collection of other companies that have grown earnings strongly.

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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.