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 up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. All else being equal, a better business will have a higher ROCE. 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 International Business Machines:
0.087 = US$9.8b ÷ (US$153b - US$41b) (Based on the trailing twelve months to March 2020.)
So, International Business Machines has an ROCE of 8.7%.
Does International Business Machines Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, International Business Machines's ROCE appears to be around the 9.9% average of the IT industry. Separate from how International Business Machines stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Readers may find more attractive investment prospects elsewhere.
International Business Machines's current ROCE of 8.7% is lower than its ROCE in the past, which was 17%, 3 years ago. This makes us wonder if the business is facing new challenges. You can see in the image below how International Business Machines's ROCE compares to its industry. Click to see more on past growth.
When considering this metric, keep in mind that it is backwards looking, and 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.
Do International Business Machines'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. 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 counter this, investors can check if a company has high current liabilities relative to total assets.
International Business Machines has current liabilities of US$41b and total assets of US$153b. Therefore its current liabilities are equivalent to approximately 27% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.
Our Take On International Business Machines's ROCE
If International Business Machines 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 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.
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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.