Today we are going to look at Datang Environment Industry Group Co., Ltd. (HKG:1272) to see whether it might be an attractive investment prospect. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
First up, we'll look at what ROCE is and how we calculate it. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. Generally speaking a higher ROCE is better. Ultimately, it is a useful but imperfect metric. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.'
So, How Do We Calculate ROCE?
The formula for calculating the return on capital employed is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
Or for Datang Environment Industry Group:
0.072 = CN¥735m ÷ (CN¥21b - CN¥10b) (Based on the trailing twelve months to June 2019.)
So, Datang Environment Industry Group has an ROCE of 7.2%.
Does Datang Environment Industry Group Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. In this analysis, Datang Environment Industry Group's ROCE appears meaningfully below the 9.9% average reported by the Commercial Services industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Aside from the industry comparison, Datang Environment Industry Group's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.
Datang Environment Industry Group's current ROCE of 7.2% is lower than 3 years ago, when the company reported a 17% ROCE. This makes us wonder if the business is facing new challenges. You can see in the image below how Datang Environment Industry Group's ROCE compares to its industry. Click to see more on 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. You can check if Datang Environment Industry Group has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Do Datang Environment Industry Group's Current Liabilities Skew 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 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Datang Environment Industry Group has total assets of CN¥21b and current liabilities of CN¥10b. As a result, its current liabilities are equal to approximately 51% of its total assets. Datang Environment Industry Group's current liabilities are fairly high, making its ROCE look better than otherwise.
Our Take On Datang Environment Industry Group's ROCE
Even so, the company reports a mediocre ROCE, and there may be better investments out there. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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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.