Today we are going to look at BYD Company Limited (HKG:1211) to see whether it might be an attractive investment prospect. 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 of all, we'll work out how to calculate ROCE. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. In brief, it is a useful tool, but it is not without drawbacks. 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?
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 BYD:
0.073 = CN¥6.4b ÷ (CN¥200b - CN¥112b) (Based on the trailing twelve months to June 2019.)
Therefore, BYD has an ROCE of 7.3%.
Does BYD Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that BYD's ROCE is meaningfully better than the 5.1% average in the Auto industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Separate from how BYD 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.
BYD's current ROCE of 7.3% is lower than 3 years ago, when the company reported a 12% ROCE. This makes us wonder if the business is facing new challenges. You can see in the image below how BYD's ROCE compares to its industry. Click to see more on past growth.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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. Since the future is so important for investors, you should check out our free report on analyst forecasts for BYD.
What Are Current Liabilities, And How Do They Affect BYD's 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 the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
BYD has total assets of CN¥200b and current liabilities of CN¥112b. As a result, its current liabilities are equal to approximately 56% of its total assets. BYD's current liabilities are fairly high, making its ROCE look better than otherwise.
What We Can Learn From BYD's ROCE
Notably, it also has a mediocre ROCE, which to my mind is not an appealing combination. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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.