Today we are going to look at International Business Machines Corporation (NYSE:IBM) to see whether it might be an attractive investment prospect. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
First, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Last but not least, we'll look at what impact its current liabilities have on 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?
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 International Business Machines:
0.097 = US$11b ÷ (US$150b - US$35b) (Based on the trailing twelve months to September 2019.)
Therefore, International Business Machines has an ROCE of 9.7%.
Does International Business Machines Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. It appears that International Business Machines's ROCE is fairly close to the IT industry average of 12%. Setting aside the industry comparison for now, International Business Machines's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Readers may find more attractive investment prospects elsewhere.
International Business Machines's current ROCE of 9.7% is lower than 3 years ago, when the company reported a 18% ROCE. Therefore we wonder if the company is facing new headwinds. You can see in the image below how International Business Machines's ROCE compares to its industry. Click to see more on past growth.
It is important to remember that ROCE shows past performance, and is 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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Do International Business Machines's Current Liabilities Skew Its ROCE?
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
International Business Machines has total assets of US$150b and current liabilities of US$35b. Therefore its current liabilities are equivalent to approximately 23% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.
The Bottom Line On International Business Machines's ROCE
That said, International Business Machines's ROCE is mediocre, there may be more attractive investments around. Of course, you might also be able to find a better stock than International Business Machines. So you may wish to see this free collection of other companies that have grown earnings strongly.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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.
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