Today we'll evaluate China Water Affairs Group Limited (HKG:855) 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.
First up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. Last but not least, we'll look at what impact its current liabilities have on 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. Generally speaking a higher ROCE is better. 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'.
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 China Water Affairs Group:
0.11 = HK$2.8b ÷ (HK$36b - HK$10b) (Based on the trailing twelve months to March 2019.)
Therefore, China Water Affairs Group has an ROCE of 11%.
Does China Water Affairs Group Have A Good ROCE?
One way to assess ROCE is to compare similar companies. In our analysis, China Water Affairs Group's ROCE is meaningfully higher than the 7.5% average in the Water Utilities industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Independently of how China Water Affairs Group compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
The image below shows how China Water Affairs Group's ROCE compares to its industry, and you can click it to see more detail on its past growth.
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. ROCE is only a point-in-time measure. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
How China Water Affairs Group'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.
China Water Affairs Group has total assets of HK$36b and current liabilities of HK$10b. As a result, its current liabilities are equal to approximately 28% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
Our Take On China Water Affairs Group's ROCE
With that in mind, China Water Affairs Group's ROCE appears pretty good. There might be better investments than China Water Affairs 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 China Water Affairs 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 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.