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Are Novacon Technology Group Limited’s (HKG:8635) High Returns Really That Great?

Simply Wall St

Today we'll evaluate Novacon Technology Group Limited (HKG:8635) to determine whether it could have potential as an investment idea. 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.

First up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting 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. In general, businesses with a higher ROCE are usually better quality. 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?

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 Novacon Technology Group:

0.30 = HK$16m ÷ (HK$72m - HK$18m) (Based on the trailing twelve months to March 2019.)

Therefore, Novacon Technology Group has an ROCE of 30%.

See our latest analysis for Novacon Technology Group

Does Novacon Technology Group Have A Good ROCE?

ROCE can be useful when making comparisons, such as between similar companies. Novacon Technology Group's ROCE appears to be substantially greater than the 7.7% average in the Software industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Putting aside its position relative to its industry for now, in absolute terms, Novacon Technology Group's ROCE is currently very good.

The image below shows how Novacon Technology Group's ROCE compares to its industry, and you can click it to see more detail on its past growth.

SEHK:8635 Past Revenue and Net Income, July 30th 2019

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is, after all, simply a snap shot of a single year. If Novacon Technology Group is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.

Do Novacon Technology Group'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. 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 counter this, investors can check if a company has high current liabilities relative to total assets.

Novacon Technology Group has total assets of HK$72m and current liabilities of HK$18m. As a result, its current liabilities are equal to approximately 25% of its total assets. A minimal amount of current liabilities limits the impact on ROCE.

What We Can Learn From Novacon Technology Group's ROCE

With low current liabilities and a high ROCE, Novacon Technology Group could be worthy of further investigation. There might be better investments than Novacon Technology Group out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.

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 editorial-team@simplywallst.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.