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Why You Should Care About China Education Group Holdings Limited’s (HKG:839) Low Return On Capital

Felix Olson

Today we are going to look at China Education Group Holdings Limited (HKG:839) to see whether it might be an attractive investment prospect. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First of all, we’ll work out how to 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. 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’.

How Do You Calculate Return On Capital Employed?

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 China Education Group Holdings:

0.083 = CN¥580m ÷ (CN¥8.7b – CN¥1.7b) (Based on the trailing twelve months to August 2018.)

So, China Education Group Holdings has an ROCE of 8.3%.

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Is China Education Group Holdings’s ROCE Good?

One way to assess ROCE is to compare similar companies. We can see China Education Group Holdings’s ROCE is meaningfully below the Consumer Services industry average of 13%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Aside from the industry comparison, China Education Group Holdings’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.

As we can see, China Education Group Holdings currently has an ROCE of 8.3%, less than the 13% it reported 3 years ago. This makes us wonder if the business is facing new challenges.

SEHK:839 Last Perf January 21st 19

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. 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 China Education Group Holdings.

Do China Education Group 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. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

China Education Group Holdings has total assets of CN¥8.7b and current liabilities of CN¥1.7b. Therefore its current liabilities are equivalent to approximately 20% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.

Our Take On China Education Group Holdings’s ROCE

That said, China Education Group Holdings’s ROCE is mediocre, there may be more attractive investments around. But note: China Education Group Holdings may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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 editorial-team@simplywallst.com.