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Today we are going to look at Design Hotels AG (FRA:LBA) to see whether it might be an attractive investment prospect. 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.
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. 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 Design Hotels:
0.26 = €3.3m ÷ (€19m - €6.4m) (Based on the trailing twelve months to December 2018.)
Therefore, Design Hotels has an ROCE of 26%.
Does Design Hotels Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. In our analysis, Design Hotels's ROCE is meaningfully higher than the 10% average in the Media industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Putting aside its position relative to its industry for now, in absolute terms, Design Hotels's ROCE is currently very good.
We can see that , Design Hotels currently has an ROCE of 26% compared to its ROCE 3 years ago, which was 20%. This makes us think about whether the company has been reinvesting shrewdly. You can see in the image below how Design Hotels's ROCE compares to its industry. Click to see more on past growth.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is only a point-in-time measure. How cyclical is Design Hotels? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
Do Design Hotels'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. 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.
Design Hotels has total liabilities of €6.4m and total assets of €19m. As a result, its current liabilities are equal to approximately 34% of its total assets. Design Hotels has a medium level of current liabilities, boosting its ROCE somewhat.
The Bottom Line On Design Hotels's ROCE
Despite this, it reports a high ROCE, and may be worth investigating further. There might be better investments than Design Hotels out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.