Today we'll look at Paradise Entertainment Limited (HKG:1180) 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, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. In general, businesses with a higher ROCE are usually better quality. 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'.
How Do You Calculate Return On Capital Employed?
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 Paradise Entertainment:
0.051 = HK$36m ÷ (HK$857m - HK$138m) (Based on the trailing twelve months to June 2019.)
Therefore, Paradise Entertainment has an ROCE of 5.1%.
Does Paradise Entertainment Have A Good ROCE?
One way to assess ROCE is to compare similar companies. Using our data, Paradise Entertainment's ROCE appears to be around the 5.1% average of the Hospitality industry. Aside from the industry comparison, Paradise Entertainment's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.
Paradise Entertainment delivered an ROCE of 5.1%, which is better than 3 years ago, as was making losses back then. That implies the business has been improving. You can click on the image below to see (in greater detail) how Paradise Entertainment'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 misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is only a point-in-time measure. How cyclical is Paradise Entertainment? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
Paradise Entertainment'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 counter this, investors can check if a company has high current liabilities relative to total assets.
Paradise Entertainment has total liabilities of HK$138m and total assets of HK$857m. As a result, its current liabilities are equal to approximately 16% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.
What We Can Learn From Paradise Entertainment's ROCE
With that in mind, we're not overly impressed with Paradise Entertainment's ROCE, so it may not be the most appealing prospect. 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 like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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.
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. Thank you for reading.