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Here’s why The Pennant Group, Inc.’s (NASDAQ:PNTG) Returns On Capital Matters So Much

Simply Wall St

Today we are going to look at The Pennant Group, Inc. (NASDAQ:PNTG) 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. Second, we'll look at its ROCE compared to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its 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?

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 Pennant Group:

0.065 = US$20m ÷ (US$363m - US$51m) (Based on the trailing twelve months to September 2019.)

So, Pennant Group has an ROCE of 6.5%.

Check out our latest analysis for Pennant Group

Is Pennant Group's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. Using our data, Pennant Group's ROCE appears to be significantly below the 11% average in the Healthcare industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Separate from how Pennant Group stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Investors may wish to consider higher-performing investments.

You can click on the image below to see (in greater detail) how Pennant Group's past growth compares to other companies.

NasdaqGS:PNTG Past Revenue and Net Income, January 1st 2020

It is important to remember that ROCE shows past performance, and is 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.

How Pennant Group'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. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Pennant Group has total liabilities of US$51m and total assets of US$363m. Therefore its current liabilities are equivalent to approximately 14% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.

Our Take On Pennant Group's ROCE

If Pennant Group continues to earn an uninspiring ROCE, there may be better places to invest. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

There are plenty of other companies that have insiders buying up shares. You probably do 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 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.

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. Thank you for reading.