Today we'll look at Lifestyle China Group Limited (HKG:2136) and reflect on its potential as an investment. 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 of all, we'll work out how to calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting 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?
The formula for calculating the return on capital employed is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
Or for Lifestyle China Group:
0.013 = CN¥183m ÷ (CN¥15b - CN¥920m) (Based on the trailing twelve months to June 2019.)
So, Lifestyle China Group has an ROCE of 1.3%.
Is Lifestyle China Group's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. In this analysis, Lifestyle China Group's ROCE appears meaningfully below the 6.5% average reported by the Multiline Retail industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Independently of how Lifestyle China Group compares to its industry, its ROCE in absolute terms is low; especially compared to the ~2.0% available in government bonds. It is likely that there are more attractive prospects out there.
We can see that, Lifestyle China Group currently has an ROCE of 1.3%, less than the 2.8% it reported 3 years ago. So investors might consider if it has had issues recently. You can see in the image below how Lifestyle China Group's ROCE compares to its industry. Click to see more on past growth.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. 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. How cyclical is Lifestyle China Group? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
Lifestyle China Group's Current Liabilities And Their Impact On 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. 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.
Lifestyle China Group has total assets of CN¥15b and current liabilities of CN¥920m. Therefore its current liabilities are equivalent to approximately 6.2% of its total assets. With barely any current liabilities, there is minimal impact on Lifestyle China Group's admittedly low ROCE.
What We Can Learn From Lifestyle China Group's ROCE
Still, investors could probably find more attractive prospects with better performance out there. Of course, you might also be able to find a better stock than Lifestyle China Group. So you may wish to see this free collection of other companies that have grown earnings strongly.
I will like Lifestyle China Group better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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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. Thank you for reading.