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Don’t Buy Daqo New Energy Corp. (NYSE:DQ) Until You Understand Its ROCE

Simply Wall St

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Today we'll look at Daqo New Energy Corp. (NYSE:DQ) and reflect on its potential as an investment. 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 of all, we'll work out how to calculate ROCE. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting 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. 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. 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 Daqo New Energy:

0.12 = US$81m ÷ (US$855m - US$150m) (Based on the trailing twelve months to December 2018.)

So, Daqo New Energy has an ROCE of 12%.

See our latest analysis for Daqo New Energy

Is Daqo New Energy's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. We can see Daqo New Energy's ROCE is around the 13% average reported by the Semiconductor industry. Regardless of where Daqo New Energy sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.

Our data shows that Daqo New Energy currently has an ROCE of 12%, compared to its ROCE of 7.3% 3 years ago. This makes us wonder if the company is improving.

NYSE:DQ Past Revenue and Net Income, April 1st 2019

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during 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 Daqo New Energy.

Do Daqo New Energy's Current Liabilities Skew Its ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that 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.

Daqo New Energy has total liabilities of US$150m and total assets of US$855m. Therefore its current liabilities are equivalent to approximately 18% of its total assets. Low current liabilities are not boosting the ROCE too much.

The Bottom Line On Daqo New Energy's ROCE

This is good to see, and with a sound ROCE, Daqo New Energy could be worth a closer look. Of course you might be able to find a better stock than Daqo New Energy. So you may wish to see this free collection of other companies that have grown earnings strongly.

I will like Daqo New Energy 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 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.