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Here’s why Pearson plc’s (LON:PSON) Returns On Capital Matters So Much

Simply Wall St

Today we are going to look at Pearson plc (LON:PSON) to see whether it might be an attractive investment prospect. 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.

Firstly, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Last but not least, we'll look at what impact its current liabilities have on 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. Generally speaking a higher ROCE is better. 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 Pearson:

0.058 = UK£380m ÷ (UK£8.0b - UK£1.4b) (Based on the trailing twelve months to June 2019.)

So, Pearson has an ROCE of 5.8%.

View our latest analysis for Pearson

Is Pearson's ROCE Good?

ROCE is commonly used for comparing the performance of similar businesses. In this analysis, Pearson's ROCE appears meaningfully below the 9.2% average reported by the Media industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Aside from the industry comparison, Pearson'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.

Our data shows that Pearson currently has an ROCE of 5.8%, compared to its ROCE of 2.6% 3 years ago. This makes us think the business might be improving. You can click on the image below to see (in greater detail) how Pearson's past growth compares to other companies.

LSE:PSON Past Revenue and Net Income, October 15th 2019

It is important to remember that ROCE shows past performance, and is not necessarily predictive. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is, after all, simply a snap shot of a single year. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Pearson.

Pearson's Current Liabilities And Their Impact On 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 counter this, investors can check if a company has high current liabilities relative to total assets.

Pearson has total assets of UK£8.0b and current liabilities of UK£1.4b. As a result, its current liabilities are equal to approximately 18% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.

Our Take On Pearson's ROCE

If Pearson continues to earn an uninspiring ROCE, there may be better places to invest. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

I will like Pearson better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

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.