Today we'll evaluate Strong Petrochemical Holdings Limited (HKG:852) 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. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect 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. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.
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 Strong Petrochemical Holdings:
0.13 = HK$204m ÷ (HK$3.2b - HK$1.6b) (Based on the trailing twelve months to June 2019.)
So, Strong Petrochemical Holdings has an ROCE of 13%.
Is Strong Petrochemical Holdings's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. In our analysis, Strong Petrochemical Holdings's ROCE is meaningfully higher than the 7.6% average in the Oil and Gas 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. Independently of how Strong Petrochemical Holdings compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
Strong Petrochemical Holdings has an ROCE of 13%, but it didn't have an ROCE 3 years ago, since it was unprofitable. That suggests the business has returned to profitability. The image below shows how Strong Petrochemical Holdings's ROCE compares to its industry, and you can click it to see more detail on its past growth.
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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Remember that most companies like Strong Petrochemical Holdings are cyclical businesses. If Strong Petrochemical Holdings is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
Do Strong Petrochemical Holdings's Current Liabilities Skew Its ROCE?
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Strong Petrochemical Holdings has total assets of HK$3.2b and current liabilities of HK$1.6b. As a result, its current liabilities are equal to approximately 50% of its total assets. Strong Petrochemical Holdings has a middling amount of current liabilities, increasing its ROCE somewhat.
Our Take On Strong Petrochemical Holdings's ROCE
Strong Petrochemical Holdings's ROCE does look good, but the level of current liabilities also contribute to that. Strong Petrochemical 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.
I will like Strong Petrochemical Holdings 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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