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Don’t Buy China Tower Corporation Limited (HKG:788) Until You Understand Its ROCE

Simply Wall St

Today we are going to look at China Tower Corporation Limited (HKG:788) 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.

Firstly, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. And finally, we'll look at how its current liabilities are impacting its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE measures the 'return' (pre-tax profit) a company generates from 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 Tower:

0.057 = CN¥12b ÷ (CN¥336b - CN¥119b) (Based on the trailing twelve months to September 2019.)

Therefore, China Tower has an ROCE of 5.7%.

Check out our latest analysis for China Tower

Is China Tower's ROCE Good?

ROCE is commonly used for comparing the performance of similar businesses. We can see China Tower's ROCE is around the 6.7% average reported by the Telecom industry. Separate from how China Tower stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Investors may wish to consider higher-performing investments.

We can see that, China Tower currently has an ROCE of 5.7% compared to its ROCE 3 years ago, which was 1.8%. This makes us wonder if the company is improving. You can see in the image below how China Tower's ROCE compares to its industry. Click to see more on past growth.

SEHK:788 Past Revenue and Net Income, November 9th 2019

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Since the future is so important for investors, you should check out our free report on analyst forecasts for China Tower.

China Tower's Current Liabilities And Their Impact On 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 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 Tower has total assets of CN¥336b and current liabilities of CN¥119b. Therefore its current liabilities are equivalent to approximately 35% of its total assets. China Tower's middling level of current liabilities have the effect of boosting its ROCE a bit.

The Bottom Line On China Tower's ROCE

Unfortunately, its ROCE is still uninspiring, and there are potentially more attractive prospects out there. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

If you are like me, then you will not want to miss this free list of growing companies that insiders are 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 editorial-team@simplywallst.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.