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Today we'll evaluate RH (NYSE:RH) to determine whether it could have potential as an investment idea. 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 of all, we'll work out how to 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 is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. 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'.
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 RH:
0.35 = US$311m ÷ (US$1.8b - US$918m) (Based on the trailing twelve months to February 2019.)
Therefore, RH has an ROCE of 35%.
Is RH's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. RH's ROCE appears to be substantially greater than the 13% average in the Specialty Retail industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Regardless of the industry comparison, in absolute terms, RH's ROCE currently appears to be excellent.
In our analysis, RH's ROCE appears to be 35%, compared to 3 years ago, when its ROCE was 12%. This makes us wonder if the company is improving.
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. 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 RH.
How RH'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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
RH has total assets of US$1.8b and current liabilities of US$918m. Therefore its current liabilities are equivalent to approximately 51% of its total assets. RH boasts an attractive ROCE, even after considering the boost from high current liabilities.
What We Can Learn From RH's ROCE
So we would be interested in doing more research here -- there may be an opportunity! 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.
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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.