In This Article:
Today we'll evaluate China Hongguang Holdings Limited (HKG:8646) to determine whether it could have potential as an investment idea. 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. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting 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. Generally speaking a higher ROCE is better. 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 China Hongguang Holdings:
0.30 = CN¥35m ÷ (CN¥191m - CN¥74m) (Based on the trailing twelve months to December 2019.)
So, China Hongguang Holdings has an ROCE of 30%.
Check out our latest analysis for China Hongguang Holdings
Is China Hongguang Holdings's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. China Hongguang Holdings's ROCE appears to be substantially greater than the 8.7% average in the Building industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of the industry comparison, in absolute terms, China Hongguang Holdings's ROCE currently appears to be excellent.
The image below shows how China Hongguang 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. If China Hongguang Holdings is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.
China Hongguang Holdings's Current Liabilities And Their Impact On Its ROCE
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.