Today we'll evaluate Cabbeen Fashion Limited (HKG:2030) to determine whether it could have potential as an investment idea. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into 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 is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested 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'.
So, How Do We Calculate ROCE?
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 Cabbeen Fashion:
0.24 = CN¥295m ÷ (CN¥2.0b - CN¥780m) (Based on the trailing twelve months to June 2019.)
Therefore, Cabbeen Fashion has an ROCE of 24%.
Is Cabbeen Fashion's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. Cabbeen Fashion's ROCE appears to be substantially greater than the 9.5% average in the Luxury industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Setting aside the comparison to its industry for a moment, Cabbeen Fashion's ROCE in absolute terms currently looks quite high.
Cabbeen Fashion's current ROCE of 24% is lower than 3 years ago, when the company reported a 33% ROCE. Therefore we wonder if the company is facing new headwinds. You can see in the image below how Cabbeen Fashion'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. 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. If Cabbeen Fashion is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
Do Cabbeen Fashion'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 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Cabbeen Fashion has total liabilities of CN¥780m and total assets of CN¥2.0b. As a result, its current liabilities are equal to approximately 39% of its total assets. Cabbeen Fashion's ROCE is boosted somewhat by its middling amount of current liabilities.
What We Can Learn From Cabbeen Fashion's ROCE
Despite this, it reports a high ROCE, and may be worth investigating further. Cabbeen Fashion 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 like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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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.