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What Can We Make Of Lithia Motors, Inc.’s (NYSE:LAD) High Return On Capital?

Simply Wall St

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Today we'll look at Lithia Motors, Inc. (NYSE:LAD) and reflect on its potential as an investment. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect its ROCE.

Understanding 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. All else being equal, a better business will have a higher ROCE. In brief, it is a useful tool, but it is not without drawbacks. 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 Lithia Motors:

0.15 = US$468m ÷ (US$5.7b - US$2.6b) (Based on the trailing twelve months to March 2019.)

So, Lithia Motors has an ROCE of 15%.

Check out our latest analysis for Lithia Motors

Is Lithia Motors's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. Lithia Motors's ROCE appears to be substantially greater than the 11% average in the Specialty Retail industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Regardless of where Lithia Motors sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.

As we can see, Lithia Motors currently has an ROCE of 15%, less than the 21% it reported 3 years ago. Therefore we wonder if the company is facing new headwinds.

NYSE:LAD Past Revenue and Net Income, May 31st 2019

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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

Lithia Motors's Current Liabilities And Their Impact On 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Lithia Motors has total assets of US$5.7b and current liabilities of US$2.6b. As a result, its current liabilities are equal to approximately 45% of its total assets. Lithia Motors has a middling amount of current liabilities, increasing its ROCE somewhat.

Our Take On Lithia Motors's ROCE

Lithia Motors's ROCE does look good, but the level of current liabilities also contribute to that. Lithia Motors 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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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 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. Thank you for reading.