Today we'll evaluate Huayu Expressway Group Limited (HKG:1823) to determine whether it could have potential as an investment idea. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
Firstly, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. 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 Huayu Expressway Group:
0.071 = HK$113m ÷ (HK$1.8b - HK$204m) (Based on the trailing twelve months to June 2019.)
Therefore, Huayu Expressway Group has an ROCE of 7.1%.
Does Huayu Expressway Group Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. We can see Huayu Expressway Group's ROCE is meaningfully below the Construction industry average of 12%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Separate from how Huayu Expressway Group stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. It is possible that there are more rewarding investments out there.
We can see that , Huayu Expressway Group currently has an ROCE of 7.1% compared to its ROCE 3 years ago, which was 5.1%. This makes us think about whether the company has been reinvesting shrewdly. The image below shows how Huayu Expressway Group's ROCE compares to its industry, and you can click it to see more detail on its past growth.
When considering ROCE, bear in mind that it reflects the past and does not necessarily 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. You can check if Huayu Expressway Group has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Do Huayu Expressway Group's Current Liabilities Skew 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. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Huayu Expressway Group has total liabilities of HK$204m and total assets of HK$1.8b. As a result, its current liabilities are equal to approximately 11% of its total assets. This very reasonable level of current liabilities would not boost the ROCE by much.
Our Take On Huayu Expressway Group's ROCE
With that in mind, we're not overly impressed with Huayu Expressway Group's ROCE, so it may not be the most appealing prospect. You might be able to find a better investment than Huayu Expressway Group. 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).
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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.