Today we'll look at A. O. Smith Corporation (NYSE:AOS) and reflect on its potential as an investment. 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. Then we'll determine how its current liabilities are affecting 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. Ultimately, it is a useful but imperfect metric. 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 A. O. Smith:
0.20 = US$460m ÷ (US$3.1b - US$767m) (Based on the trailing twelve months to December 2019.)
So, A. O. Smith has an ROCE of 20%.
Does A. O. Smith Have A Good ROCE?
One way to assess ROCE is to compare similar companies. In our analysis, A. O. Smith's ROCE is meaningfully higher than the 12% average in the Building industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Putting aside its position relative to its industry for now, in absolute terms, A. O. Smith's ROCE is currently very good.
You can click on the image below to see (in greater detail) how A. O. Smith's past growth compares to other companies.
It is important to remember that ROCE shows past performance, and is 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 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 A. O. Smith.
What Are Current Liabilities, And How Do They Affect A. O. Smith's ROCE?
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that 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 counter this, investors can check if a company has high current liabilities relative to total assets.
A. O. Smith has current liabilities of US$767m and total assets of US$3.1b. Therefore its current liabilities are equivalent to approximately 25% of its total assets. This is quite a low level of current liabilities which would not greatly boost the already high ROCE.
What We Can Learn From A. O. Smith's ROCE
This is good to see, and with such a high ROCE, A. O. Smith may be worth a closer look. A. O. Smith shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
I will like A. O. Smith better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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