Today we'll look at Sterlite Technologies Limited (NSE:STRTECH) 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.
Firstly, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
What is 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. 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'.
So, How Do We Calculate ROCE?
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 Sterlite Technologies:
0.36 = ₹10b ÷ (₹70b - ₹41b) (Based on the trailing twelve months to June 2019.)
So, Sterlite Technologies has an ROCE of 36%.
Does Sterlite Technologies Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. In our analysis, Sterlite Technologies's ROCE is meaningfully higher than the 13% average in the Communications 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, Sterlite Technologies's ROCE is currently very good.
Our data shows that Sterlite Technologies currently has an ROCE of 36%, compared to its ROCE of 23% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly. The image below shows how Sterlite Technologies's ROCE compares to its industry, and you can click it to see more detail on its past growth.
Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. 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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Do Sterlite Technologies's Current Liabilities Skew 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 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.
Sterlite Technologies has total assets of ₹70b and current liabilities of ₹41b. As a result, its current liabilities are equal to approximately 59% of its total assets. While a high level of current liabilities boosts its ROCE, Sterlite Technologies's returns are still very good.
What We Can Learn From Sterlite Technologies's ROCE
So to us, the company is potentially worth investigating further. Sterlite Technologies looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.
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If you spot an error that warrants correction, please contact the editor at email@example.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.