Today we'll evaluate China Shenhua Energy Company Limited (HKG:1088) to determine whether it could have potential as an investment idea. 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, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Last but not least, we'll look at what impact its current liabilities have on 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. All else being equal, a better business will have a higher ROCE. 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 China Shenhua Energy:
0.15 = CN¥71b ÷ (CN¥565b - CN¥96b) (Based on the trailing twelve months to September 2019.)
So, China Shenhua Energy has an ROCE of 15%.
Does China Shenhua Energy Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. China Shenhua Energy's ROCE appears to be substantially greater than the 7.6% average in the Oil and Gas 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. Independently of how China Shenhua Energy compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
We can see that, China Shenhua Energy currently has an ROCE of 15% compared to its ROCE 3 years ago, which was 9.1%. This makes us wonder if the company is improving. The image below shows how China Shenhua Energy's ROCE compares to its industry, and you can click it to see more detail on its past growth.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is, after all, simply a snap shot of a single year. Given the industry it operates in, China Shenhua Energy could be considered cyclical. Since the future is so important for investors, you should check out our free report on analyst forecasts for China Shenhua Energy.
Do China Shenhua Energy'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. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
China Shenhua Energy has total liabilities of CN¥96b and total assets of CN¥565b. As a result, its current liabilities are equal to approximately 17% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
Our Take On China Shenhua Energy's ROCE
With that in mind, China Shenhua Energy's ROCE appears pretty good. There might be better investments than China Shenhua Energy 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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