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What Can We Make Of Compass Group PLC’s (LON:CPG) High Return On Capital?

Today we'll look at Compass Group PLC (LON:CPG) and reflect on its potential as an investment. 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 of all, we'll work out how to 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.

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. 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?

The formula for calculating the return on capital employed is:

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Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

Or for Compass Group:

0.22 = UK£1.7b ÷ (UK£13b - UK£4.8b) (Based on the trailing twelve months to March 2019.)

So, Compass Group has an ROCE of 22%.

See our latest analysis for Compass Group

Is Compass Group's ROCE Good?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that Compass Group's ROCE is meaningfully better than the 7.5% average in the Hospitality 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, Compass Group's ROCE is currently very good.

You can see in the image below how Compass Group's ROCE compares to its industry. Click to see more on past growth.

LSE:CPG Past Revenue and Net Income, October 2nd 2019
LSE:CPG Past Revenue and Net Income, October 2nd 2019

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. 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 Compass Group.

How Compass Group's Current Liabilities Impact Its ROCE

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counter this, investors can check if a company has high current liabilities relative to total assets.

Compass Group has total assets of UK£13b and current liabilities of UK£4.8b. Therefore its current liabilities are equivalent to approximately 38% of its total assets. Compass Group has a medium level of current liabilities, boosting its ROCE somewhat.

Our Take On Compass Group's ROCE

Even so, it has a great ROCE, and could be an attractive prospect for further research. There might be better investments than Compass Group 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.

I will like Compass Group better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider 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 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.