Today we'll evaluate Towngas China Company Limited (HKG:1083) to determine whether it could have potential as an investment idea. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.
First up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
What is Return On Capital Employed (ROCE)?
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. 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?
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 Towngas China:
0.067 = HK$1.7b ÷ (HK$35b - HK$10b) (Based on the trailing twelve months to June 2019.)
Therefore, Towngas China has an ROCE of 6.7%.
Is Towngas China's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. In this analysis, Towngas China's ROCE appears meaningfully below the 9.4% average reported by the Gas Utilities industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Aside from the industry comparison, Towngas China's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Readers may find more attractive investment prospects elsewhere.
We can see that, Towngas China currently has an ROCE of 6.7% compared to its ROCE 3 years ago, which was 4.9%. This makes us think about whether the company has been reinvesting shrewdly. The image below shows how Towngas China's ROCE compares to its industry, and you can click it to see more detail on its past growth.
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. ROCE is only a point-in-time measure. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Towngas China'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. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counteract this, we check if a company has high current liabilities, relative to its total assets.
Towngas China has total assets of HK$35b and current liabilities of HK$10b. As a result, its current liabilities are equal to approximately 29% 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 Towngas China's ROCE
That said, Towngas China's ROCE is mediocre, there may be more attractive investments around. Of course, you might also be able to find a better stock than Towngas China. So you may wish to see this free collection of other companies that have grown earnings strongly.
I will like Towngas China better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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.
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