Yahoo Finance Why Pearson plc’s (LON:PSON) Return On Capital Employed Might Be A Concern
Today we'll evaluate Pearson plc (LON:PSON) to determine whether it could have potential as an investment idea. 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, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Then we'll determine how its current liabilities are affecting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. Generally speaking a higher ROCE is better. 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'.
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 Pearson:
0.061 = UK£375m ÷ (UK£7.7b - UK£1.5b) (Based on the trailing twelve months to December 2019.)
So, Pearson has an ROCE of 6.1%.
Check out our latest analysis for Pearson
Does Pearson Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. Using our data, Pearson's ROCE appears to be significantly below the 9.5% average in the Media industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Aside from the industry comparison, Pearson's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.
We can see that, Pearson currently has an ROCE of 6.1% compared to its ROCE 3 years ago, which was 3.9%. This makes us think about whether the company has been reinvesting shrewdly. You can click on the image below to see (in greater detail) how Pearson's past growth compares to other companies.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is only a point-in-time measure. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Do Pearson'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 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.
Pearson has total assets of UK£7.7b and current liabilities of UK£1.5b. Therefore its current liabilities are equivalent to approximately 20% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.
Our Take On Pearson's ROCE
With that in mind, we're not overly impressed with Pearson's ROCE, so it may not be the most appealing prospect. Of course, you might also be able to find a better stock than Pearson. So you may wish to see this free collection of other companies that have grown earnings strongly.
There are plenty of other companies that have insiders buying up shares. You probably do not want to miss this free list of growing companies that insiders are buying.
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.
