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Why Pearson plc’s (LON:PSON) Use Of Investor Capital Doesn’t Look Great

Victor Youngblood

Today we’ll look at Pearson plc (LON:PSON) and reflect on its potential as an investment. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First up, we’ll look at what ROCE is and how we calculate it. Then we’ll compare its ROCE to similar companies. Finally, we’ll look at how its current liabilities affect its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.’

So, How Do We Calculate ROCE?

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 Pearson:

0.066 = UK£327m ÷ (UK£7.6b – UK£2.0b) (Based on the trailing twelve months to June 2018.)

So, Pearson has an ROCE of 6.6%.

See our latest analysis for Pearson

Does Pearson Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. Using our data, Pearson’s ROCE appears to be significantly below the 9.0% average in 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. It is possible that there are more rewarding investments out there.

Our data shows that Pearson currently has an ROCE of 6.6%, compared to its ROCE of 4.3% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly.

LSE:PSON Last Perf January 24th 19

When considering this metric, keep in mind that it is backwards looking, and 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Since the future is so important for investors, you should check out our free report on analyst forecasts for Pearson.

How Pearson’s Current Liabilities Impact Its ROCE

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, 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.

Pearson has total assets of UK£7.6b and current liabilities of UK£2.0b. As a result, its current liabilities are equal to approximately 26% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.

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.

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

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.