Today we’ll evaluate Aaron Industries Limited (NSE:AARON) to determine whether it could have potential as an investment idea. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First up, we’ll look at what ROCE is and how we calculate it. Second, we’ll look at its ROCE compared to similar companies. And finally, we’ll look at how its current liabilities are impacting 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. 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’.
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 Aaron Industries:
0.40 = ₹16m ÷ (₹69m – ₹29m) (Based on the trailing twelve months to March 2018.)
So, Aaron Industries has an ROCE of 40%.
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Is Aaron Industries’s ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. Using our data, we find that Aaron Industries’s ROCE is meaningfully better than the 15% average in the Machinery industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Setting aside the comparison to its industry for a moment, Aaron Industries’s ROCE in absolute terms currently looks quite high.
As we can see, Aaron Industries currently has an ROCE of 40% compared to its ROCE 3 years ago, which was 23%. This makes us wonder if the company is improving.
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. ROCE is, after all, simply a snap shot of a single year. You can check if Aaron Industries has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.