Today we are going to look at Guangnan (Holdings) Limited (HKG:1203) to see whether it might be an attractive investment prospect. Specifically, we'll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.
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.
Understanding Return On Capital Employed (ROCE)
ROCE measures the 'return' (pre-tax profit) a company generates from 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. 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 Guangnan (Holdings):
0.036 = HK$95m ÷ (HK$3.0b - HK$382m) (Based on the trailing twelve months to June 2019.)
So, Guangnan (Holdings) has an ROCE of 3.6%.
Is Guangnan (Holdings)'s ROCE Good?
One way to assess ROCE is to compare similar companies. In this analysis, Guangnan (Holdings)'s ROCE appears meaningfully below the 7.8% average reported by the Metals and Mining industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Putting aside Guangnan (Holdings)'s performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. It is likely that there are more attractive prospects out there.
We can see that, Guangnan (Holdings) currently has an ROCE of 3.6% compared to its ROCE 3 years ago, which was 2.2%. This makes us wonder if the company is improving. The image below shows how Guangnan (Holdings)'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. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is only a point-in-time measure. Remember that most companies like Guangnan (Holdings) are cyclical businesses. You can check if Guangnan (Holdings) has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Do Guangnan (Holdings)'s Current Liabilities Skew Its ROCE?
Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Guangnan (Holdings) has total assets of HK$3.0b and current liabilities of HK$382m. Therefore its current liabilities are equivalent to approximately 13% of its total assets. This is a modest level of current liabilities, which will have a limited impact on the ROCE.
What We Can Learn From Guangnan (Holdings)'s ROCE
While that is good to see, Guangnan (Holdings) has a low ROCE and does not look attractive in this analysis. You might be able to find a better investment than Guangnan (Holdings). If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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.
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