Today we'll look at Shanghai Prime Machinery Company Limited (HKG:2345) 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. Second, we'll look at its ROCE compared to similar companies. Last but not least, we'll look at what impact its current liabilities have on 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. All else being equal, a better business will have a higher ROCE. Overall, it is a valuable metric that has its flaws. 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 Shanghai Prime Machinery:
0.023 = CN¥145m ÷ (CN¥9.6b - CN¥3.4b) (Based on the trailing twelve months to December 2019.)
So, Shanghai Prime Machinery has an ROCE of 2.3%.
View our latest analysis for Shanghai Prime Machinery
Does Shanghai Prime Machinery Have A Good ROCE?
One way to assess ROCE is to compare similar companies. In this analysis, Shanghai Prime Machinery's ROCE appears meaningfully below the 8.2% average reported by the Machinery industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Regardless of how Shanghai Prime Machinery stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). It is likely that there are more attractive prospects out there.
Shanghai Prime Machinery's current ROCE of 2.3% is lower than 3 years ago, when the company reported a 4.9% ROCE. This makes us wonder if the business is facing new challenges. You can click on the image below to see (in greater detail) how Shanghai Prime Machinery's past growth compares to other companies.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. 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 Shanghai Prime Machinery has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.