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Shareholders Should Look Hard At NOW Inc.’s (NYSE:DNOW) 5.8%Return On Capital

Simply Wall St

Today we'll look at NOW Inc. (NYSE:DNOW) 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 of all, we'll work out how to 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.

What is 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'.

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 NOW:

0.058 = US$76m ÷ (US$1.8b - US$470m) (Based on the trailing twelve months to September 2019.)

Therefore, NOW has an ROCE of 5.8%.

View our latest analysis for NOW

Does NOW Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. We can see NOW's ROCE is meaningfully below the Trade Distributors industry average of 9.0%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Aside from the industry comparison, NOW's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.

NOW has an ROCE of 5.8%, but it didn't have an ROCE 3 years ago, since it was unprofitable. That implies the business has been improving. You can click on the image below to see (in greater detail) how NOW's past growth compares to other companies.

NYSE:DNOW Past Revenue and Net Income, November 27th 2019

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. 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 NOW's Current Liabilities Skew Its ROCE?

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

NOW has total liabilities of US$470m and total assets of US$1.8b. As a result, its current liabilities are equal to approximately 26% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.

What We Can Learn From NOW's ROCE

If NOW continues to earn an uninspiring ROCE, there may be better places to invest. Of course, you might also be able to find a better stock than NOW. So you may wish to see this free collection of other companies that have grown earnings strongly.

I will like NOW better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

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.

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