Today we'll look at Microsoft Corporation (NASDAQ:MSFT) 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.
First of all, we'll work out how to calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting 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. Generally speaking a higher ROCE is better. 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.'
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 Microsoft:
0.20 = US$43b ÷ (US$287b - US$69b) (Based on the trailing twelve months to June 2019.)
Therefore, Microsoft has an ROCE of 20%.
Is Microsoft's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. In our analysis, Microsoft's ROCE is meaningfully higher than the 9.9% average in the Software industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Separate from Microsoft's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
You can click on the image below to see (in greater detail) how Microsoft's past growth compares to other companies.
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. ROCE is only a point-in-time measure. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Microsoft.
How Microsoft's Current Liabilities Impact 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. 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Microsoft has total liabilities of US$69b and total assets of US$287b. As a result, its current liabilities are equal to approximately 24% of its total assets. Low current liabilities are not boosting the ROCE too much.
What We Can Learn From Microsoft's ROCE
With that in mind, Microsoft's ROCE appears pretty good. Microsoft shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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