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Today we’ll look at Prosperous Industrial (Holdings) Limited (HKG:1731) and reflect on its potential as an investment. 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.
Firstly, we’ll go over how we calculate ROCE. Next, we’ll compare it to others in its industry. Finally, we’ll look at how its current liabilities affect 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. 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?
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 Prosperous Industrial (Holdings):
0.13 = US$24m ÷ (US$165m – US$51m) (Based on the trailing twelve months to June 2018.)
Therefore, Prosperous Industrial (Holdings) has an ROCE of 13%.
Is Prosperous Industrial (Holdings)’s ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. Prosperous Industrial (Holdings)’s ROCE appears to be substantially greater than the 9.4% average in the Luxury industry. I think that’s good to see, since it implies the company is better than other companies at making the most of its capital. Separate from Prosperous Industrial (Holdings)’s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
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 Prosperous Industrial (Holdings) has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Prosperous Industrial (Holdings)’s Current Liabilities And Their Impact On Its ROCE
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Prosperous Industrial (Holdings) has total liabilities of US$51m and total assets of US$165m. As a result, its current liabilities are equal to approximately 31% of its total assets. With this level of current liabilities, Prosperous Industrial (Holdings)’s ROCE is boosted somewhat.
The Bottom Line On Prosperous Industrial (Holdings)’s ROCE
Prosperous Industrial (Holdings)’s ROCE does look good, but the level of current liabilities also contribute to that. 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.
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 firstname.lastname@example.org.