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Today we'll evaluate Edgeware AB (publ) (STO:EDGE) 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.
Firstly, we'll go over how we calculate ROCE. 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 amount of pre-tax profits a company can generate from the capital employed in its business. Generally speaking a higher ROCE is better. 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'.
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 Edgeware:
0.021 = kr5.1m ÷ (kr310m - kr66m) (Based on the trailing twelve months to March 2019.)
Therefore, Edgeware has an ROCE of 2.1%.
Is Edgeware's ROCE Good?
One way to assess ROCE is to compare similar companies. In this analysis, Edgeware's ROCE appears meaningfully below the 12% average reported by the Communications industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Independently of how Edgeware compares to its industry, its ROCE in absolute terms is low; especially compared to the ~0.4% available in government bonds. Readers may wish to look for more rewarding investments.
Edgeware's current ROCE of 2.1% is lower than its ROCE in the past, which was 19%, 3 years ago. Therefore we wonder if the company is facing new headwinds. You can see in the image below how Edgeware's ROCE compares to its industry. Click to see more on past growth.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
What Are Current Liabilities, And How Do They Affect Edgeware's ROCE?
Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that need to be paid within 12 months. 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.
Edgeware has total assets of kr310m and current liabilities of kr66m. As a result, its current liabilities are equal to approximately 21% of its total assets. This is a modest level of current liabilities, which will have a limited impact on the ROCE.
What We Can Learn From Edgeware's ROCE
While that is good to see, Edgeware has a low ROCE and does not look attractive in this analysis. Of course, you might also be able to find a better stock than Edgeware. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
If you spot an error that warrants correction, please contact the editor at email@example.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.