Today we'll evaluate Tencent Holdings Limited (HKG:700) to determine whether it could have potential as an investment idea. 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 up, we'll look at what ROCE is and how we calculate it. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect 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. Overall, it is a valuable metric that has its flaws. 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 Tencent Holdings:
0.14 = CN¥87b ÷ (CN¥817b - CN¥202b) (Based on the trailing twelve months to June 2019.)
Therefore, Tencent Holdings has an ROCE of 14%.
Is Tencent Holdings's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. Using our data, Tencent Holdings's ROCE appears to be around the 16% average of the Interactive Media and Services industry. Regardless of where Tencent Holdings sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
Tencent Holdings's current ROCE of 14% is lower than its ROCE in the past, which was 20%, 3 years ago. This makes us wonder if the business is facing new challenges. You can see in the image below how Tencent Holdings's ROCE compares to its industry. Click to see more on past growth.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. 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, after all, simply a snap shot of a single year. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Tencent Holdings.
Do Tencent Holdings'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. 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Tencent Holdings has total liabilities of CN¥202b and total assets of CN¥817b. Therefore its current liabilities are equivalent to approximately 25% of its total assets. Low current liabilities are not boosting the ROCE too much.
Our Take On Tencent Holdings's ROCE
With that in mind, Tencent Holdings's ROCE appears pretty good. Tencent Holdings 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.
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 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.