Today we’ll evaluate Duxton Water Limited (ASX:D2O) 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 of all, we’ll work out how to calculate ROCE. Next, we’ll compare it to others in its industry. And finally, we’ll look at how its current liabilities are impacting 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?
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 Duxton Water:
0.034 = AU$2.1m ÷ (AU$100m – AU$1.3m) (Based on the trailing twelve months to June 2018.)
Therefore, Duxton Water has an ROCE of 3.4%.
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Is Duxton Water’s ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. We can see Duxton Water’s ROCE is meaningfully below the Water Utilities industry average of 6.1%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Putting aside Duxton Water’s performance relative to its industry, its ROCE in absolute terms is poor – considering the risk of owning stocks compared to government bonds. It is likely that there are more attractive prospects out there.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. 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.
Duxton Water’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 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Duxton Water has total assets of AU$100m and current liabilities of AU$1.3m. Therefore its current liabilities are equivalent to approximately 1.3% of its total assets. With barely any current liabilities, there is minimal impact on Duxton Water’s admittedly low ROCE.
What We Can Learn From Duxton Water’s ROCE
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To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
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.