Today we’ll look at Varian Medical Systems, Inc. (NYSE:VAR) and reflect on its potential as an investment. 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. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the ‘return’ (pre-tax profit) a company generates from capital employed in its business. In general, businesses with a higher ROCE are usually better quality. Ultimately, it is a useful but imperfect metric. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.’
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 Varian Medical Systems:
0.26 = US$500m ÷ (US$3.3b – US$1.3b) (Based on the trailing twelve months to September 2018.)
Therefore, Varian Medical Systems has an ROCE of 26%.
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Is Varian Medical Systems’s ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that Varian Medical Systems’s ROCE is meaningfully better than the 11% average in the Medical Equipment 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, Varian Medical Systems’s ROCE in absolute terms currently looks quite high.
Our data shows that Varian Medical Systems currently has an ROCE of 26%, compared to its ROCE of 19% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly.
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, after all, simply a snap shot of a single year. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Varian Medical Systems.