Today we'll evaluate Zhejiang Tengy Environmental Technology Co., Ltd (HKG:1527) to determine whether it could have potential as an investment idea. 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.
First up, we'll look at what ROCE is and how we calculate it. Next, we'll compare it to others in its industry. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
What is 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. 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 Zhejiang Tengy Environmental Technology:
0.059 = CN¥44m ÷ (CN¥1.5b - CN¥758m) (Based on the trailing twelve months to June 2019.)
Therefore, Zhejiang Tengy Environmental Technology has an ROCE of 5.9%.
Does Zhejiang Tengy Environmental Technology Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, Zhejiang Tengy Environmental Technology's ROCE appears to be significantly below the 11% average in the Machinery industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Separate from how Zhejiang Tengy Environmental Technology stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Investors may wish to consider higher-performing investments.
We can see that, Zhejiang Tengy Environmental Technology currently has an ROCE of 5.9%, less than the 26% it reported 3 years ago. This makes us wonder if the business is facing new challenges. You can click on the image below to see (in greater detail) how Zhejiang Tengy Environmental Technology's past growth compares to other companies.
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. You can check if Zhejiang Tengy Environmental Technology has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
What Are Current Liabilities, And How Do They Affect Zhejiang Tengy Environmental Technology's ROCE?
Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Zhejiang Tengy Environmental Technology has total liabilities of CN¥758m and total assets of CN¥1.5b. As a result, its current liabilities are equal to approximately 50% of its total assets. Zhejiang Tengy Environmental Technology has a fairly high level of current liabilities, meaningfully impacting its ROCE.
Our Take On Zhejiang Tengy Environmental Technology's ROCE
Notably, it also has a mediocre ROCE, which to my mind is not an appealing combination. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
I will like Zhejiang Tengy Environmental Technology 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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