Today we are going to look at A. O. Smith Corporation (NYSE:AOS) to see whether it might be an attractive investment prospect. 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. Finally, we’ll look at how its current liabilities affect its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the 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’.
How Do You Calculate Return On Capital Employed?
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 A. O. Smith:
0.25 = US$562m ÷ (US$3.1b – US$785m) (Based on the trailing twelve months to December 2018.)
Therefore, A. O. Smith has an ROCE of 25%.
Does A. O. Smith Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. In our analysis, A. O. Smith’s ROCE is meaningfully higher than the 15% average in the Building industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of the industry comparison, in absolute terms, A. O. Smith’s ROCE currently appears to be excellent.
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. Since the future is so important for investors, you should check out our free report on analyst forecasts for A. O. Smith.
What Are Current Liabilities, And How Do They Affect A. O. Smith’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 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
A. O. Smith has total assets of US$3.1b and current liabilities of US$785m. As a result, its current liabilities are equal to approximately 26% of its total assets. This is quite a low level of current liabilities which would not greatly boost the already high ROCE.
The Bottom Line On A. O. Smith’s ROCE
Low current liabilities and high ROCE is a good combination, making A. O. Smith look quite interesting. But note: A. O. Smith may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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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.