Today we’ll look at Eaton Corporation plc (NYSE:ETN) 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.
First of all, we’ll work out how to calculate ROCE. Next, we’ll compare it to others in its industry. Then we’ll determine how its current liabilities are affecting its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. All else being equal, a better business will have a higher ROCE. 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 Eaton:
0.11 = US$2.5b ÷ (US$32b – US$5.3b) (Based on the trailing twelve months to September 2018.)
So, Eaton has an ROCE of 11%.
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Is Eaton’s ROCE Good?
One way to assess ROCE is to compare similar companies. It appears that Eaton’s ROCE is fairly close to the Electrical industry average of 11%. Separate from Eaton’s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
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 Eaton.
What Are Current Liabilities, And How Do They Affect Eaton’s ROCE?
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Eaton has total liabilities of US$5.3b and total assets of US$32b. As a result, its current liabilities are equal to approximately 17% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.
What We Can Learn From Eaton’s ROCE
This is good to see, and with a sound ROCE, Eaton could be worth a closer look. But note: Eaton may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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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 email@example.com.