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Today we’ll look at Affluent Foundation Holdings Limited (HKG:1757) 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.
Firstly, we’ll go over how we calculate ROCE. Next, we’ll compare it to others in its industry. Then we’ll determine how its current liabilities are affecting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the business. All else being equal, a better business will have a higher ROCE. 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’.
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 Affluent Foundation Holdings:
0.18 = HK$26m ÷ (HK$259m – HK$78m) (Based on the trailing twelve months to September 2018.)
So, Affluent Foundation Holdings has an ROCE of 18%.
Is Affluent Foundation Holdings’s ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. Affluent Foundation Holdings’s ROCE appears to be substantially greater than the 14% average in the Construction industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Regardless of where Affluent Foundation Holdings sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
Affluent Foundation Holdings’s current ROCE of 18% is lower than 3 years ago, when the company reported a 61% ROCE. Therefore we wonder if the company is facing new headwinds.
Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is, after all, simply a snap shot of a single year. You can check if Affluent Foundation Holdings has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Do Affluent Foundation Holdings’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. 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.
Affluent Foundation Holdings has total assets of HK$259m and current liabilities of HK$78m. As a result, its current liabilities are equal to approximately 30% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
Our Take On Affluent Foundation Holdings’s ROCE
With that in mind, Affluent Foundation Holdings’s ROCE appears pretty good. You might be able to find a better buy than Affluent Foundation 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).
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.