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Today we'll look at Nanosonics Limited (ASX:NAN) and reflect on its potential as an investment. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
Firstly, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Finally, we'll look at how its current liabilities affect 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. In general, businesses with a higher ROCE are usually better quality. 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 Nanosonics:
0.078 = AU$8.2m ÷ (AU$117m - AU$12m) (Based on the trailing twelve months to December 2018.)
Therefore, Nanosonics has an ROCE of 7.8%.
Check out our latest analysis for Nanosonics
Is Nanosonics's ROCE Good?
One way to assess ROCE is to compare similar companies. Using our data, Nanosonics's ROCE appears to be significantly below the 15% average in the Medical Equipment industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Setting aside the industry comparison for now, Nanosonics's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.
Nanosonics reported an ROCE of 7.8% -- better than 3 years ago, when the company didn't make a profit. That implies the business has been improving. You can see in the image below how Nanosonics's ROCE compares to its industry. Click to see more on past growth.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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. Since the future is so important for investors, you should check out our free report on analyst forecasts for Nanosonics.