Today we'll look at China Wood Optimization (Holding) Limited (HKG:1885) and reflect on its potential as an investment. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First of all, we'll work out how to calculate ROCE. Then we'll compare its ROCE 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 measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. All else being equal, a better business will have a higher ROCE. 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 Wood Optimization (Holding):
0.13 = CN¥86m ÷ (CN¥754m - CN¥73m) (Based on the trailing twelve months to June 2019.)
Therefore, China Wood Optimization (Holding) has an ROCE of 13%.
Is China Wood Optimization (Holding)'s ROCE Good?
One way to assess ROCE is to compare similar companies. It appears that China Wood Optimization (Holding)'s ROCE is fairly close to the Forestry industry average of 11%. Separate from China Wood Optimization (Holding)'s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
China Wood Optimization (Holding)'s current ROCE of 13% is lower than its ROCE in the past, which was 19%, 3 years ago. So investors might consider if it has had issues recently. You can click on the image below to see (in greater detail) how China Wood Optimization (Holding)'s past growth compares to other companies.
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, after all, simply a snap shot of a single year. If China Wood Optimization (Holding) is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
China Wood Optimization (Holding)'s Current Liabilities And Their Impact On Its ROCE
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
China Wood Optimization (Holding) has total assets of CN¥754m and current liabilities of CN¥73m. As a result, its current liabilities are equal to approximately 9.6% of its total assets. With low current liabilities, China Wood Optimization (Holding)'s decent ROCE looks that much more respectable.
The Bottom Line On China Wood Optimization (Holding)'s ROCE
This is good to see, and while better prospects may exist, China Wood Optimization (Holding) seems worth researching further. China Wood Optimization (Holding) looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.