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Examining Meggitt PLC’s (LON:MGGT) Weak Return On Capital Employed

Simply Wall St

Today we'll evaluate Meggitt PLC (LON:MGGT) to determine whether it could have potential as an investment idea. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

First up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. Then we'll determine how its current liabilities are affecting 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. Overall, it is a valuable metric that has its flaws. 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 Meggitt:

0.056 = UK£232m ÷ (UK£4.8b - UK£695m) (Based on the trailing twelve months to June 2019.)

Therefore, Meggitt has an ROCE of 5.6%.

View our latest analysis for Meggitt

Does Meggitt Have A Good ROCE?

One way to assess ROCE is to compare similar companies. In this analysis, Meggitt's ROCE appears meaningfully below the 12% average reported by the Aerospace & Defense industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Separate from how Meggitt stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Investors may wish to consider higher-performing investments.

Our data shows that Meggitt currently has an ROCE of 5.6%, compared to its ROCE of 4.1% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly. The image below shows how Meggitt's ROCE compares to its industry, and you can click it to see more detail on its past growth.

LSE:MGGT Past Revenue and Net Income, September 25th 2019

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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Since the future is so important for investors, you should check out our free report on analyst forecasts for Meggitt.

Meggitt's Current Liabilities And Their Impact On Its ROCE

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Meggitt has total liabilities of UK£695m and total assets of UK£4.8b. Therefore its current liabilities are equivalent to approximately 14% of its total assets. It is good to see a restrained amount of current liabilities, as this limits the effect on ROCE.

Our Take On Meggitt's ROCE

If Meggitt continues to earn an uninspiring ROCE, there may be better places to invest. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

Meggitt is not the only stock that insiders are buying. For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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 editorial-team@simplywallst.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.