Today we'll evaluate China MeiDong Auto Holdings Limited (HKG:1268) 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. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. In general, businesses with a higher ROCE are usually better quality. In brief, it is a useful tool, but it is not without drawbacks. 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 China MeiDong Auto Holdings:
0.26 = CN¥608m ÷ (CN¥5.1b - CN¥2.7b) (Based on the trailing twelve months to June 2019.)
So, China MeiDong Auto Holdings has an ROCE of 26%.
Is China MeiDong Auto Holdings's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. Using our data, we find that China MeiDong Auto Holdings's ROCE is meaningfully better than the 12% average in the Specialty Retail 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, China MeiDong Auto Holdings's ROCE is currently very good.
You can see in the image below how China MeiDong Auto Holdings's ROCE compares to its industry. Click to see more on past growth.
Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. 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 China MeiDong Auto Holdings.
Do China MeiDong Auto Holdings'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 counter this, investors can check if a company has high current liabilities relative to total assets.
China MeiDong Auto Holdings has total assets of CN¥5.1b and current liabilities of CN¥2.7b. As a result, its current liabilities are equal to approximately 54% of its total assets. China MeiDong Auto Holdings's high level of current liabilities boost the ROCE - but its ROCE is still impressive.
Our Take On China MeiDong Auto Holdings's ROCE
So we would be interested in doing more research here -- there may be an opportunity! There might be better investments than China MeiDong Auto Holdings 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 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.