Why You Should Care About China Literature Limited’s (HKG:772) Low Return On Capital
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Today we’ll look at China Literature Limited (HKG:772) and reflect on its potential as an investment. In particular, we’ll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.
Firstly, we’ll go over how we calculate ROCE. Then we’ll compare its ROCE to similar companies. 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. All else being equal, a better business will have a higher ROCE. Ultimately, it is a useful but imperfect metric. 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?
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 China Literature:
0.049 = CN¥458m ÷ (CN¥16b – CN¥2.1b) (Based on the trailing twelve months to June 2018.)
So, China Literature has an ROCE of 4.9%.
View our latest analysis for China Literature
Does China Literature Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. We can see China Literature’s ROCE is meaningfully below the Media industry average of 10%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Putting aside China Literature’s performance relative to its industry, its ROCE in absolute terms is poor – considering the risk of owning stocks compared to government bonds. It is likely that there are more attractive prospects out there.
China Literature reported an ROCE of 4.9% — better than 3 years ago, when the company didn’t make a profit. This makes us wonder if the company is improving.
Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately 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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
What Are Current Liabilities, And How Do They Affect China Literature’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 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
China Literature has total assets of CN¥16b and current liabilities of CN¥2.1b. Therefore its current liabilities are equivalent to approximately 13% of its total assets. This is not a high level of current liabilities, which would not boost the ROCE by much.
What We Can Learn From China Literature’s ROCE
That’s not a bad thing, however China Literature has a weak ROCE and may not be an attractive investment. You might be able to find a better buy than China Literature. 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).
I will like China Literature better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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.
