Today we are going to look at Tao Heung Holdings Limited (HKG:573) to see whether it might be an attractive investment prospect. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
First up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its 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. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.
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 Tao Heung Holdings:
0.081 = HK$191m ÷ (HK$3.2b - HK$819m) (Based on the trailing twelve months to June 2019.)
So, Tao Heung Holdings has an ROCE of 8.1%.
Does Tao Heung Holdings Have A Good ROCE?
One way to assess ROCE is to compare similar companies. In our analysis, Tao Heung Holdings's ROCE is meaningfully higher than the 5.0% average in the Hospitality 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. Aside from the industry comparison, Tao Heung Holdings's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.
The image below shows how Tao Heung Holdings's ROCE compares to its industry, and you can click it to see more detail on its 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. ROCE is, after all, simply a snap shot of a single year. You can check if Tao Heung Holdings has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
Do Tao Heung Holdings's Current Liabilities Skew Its 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Tao Heung Holdings has total liabilities of HK$819m and total assets of HK$3.2b. Therefore its current liabilities are equivalent to approximately 26% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.
The Bottom Line On Tao Heung Holdings's ROCE
With that in mind, we're not overly impressed with Tao Heung Holdings's ROCE, so it may not be the most appealing prospect. You might be able to find a better investment than Tao Heung Holdings. 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).
There are plenty of other companies that have insiders buying up shares. You probably do not want to miss this free list of growing companies that insiders are buying.
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 email@example.com. 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.