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Today we'll evaluate Air China Limited (HKG:753) 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.
Firstly, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. And finally, we'll look at how its current liabilities are impacting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested 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?
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 Air China:
0.066 = CN¥14b ÷ (CN¥281b - CN¥75b) (Based on the trailing twelve months to March 2019.)
Therefore, Air China has an ROCE of 6.6%.
View our latest analysis for Air China
Does Air China Have A Good ROCE?
One way to assess ROCE is to compare similar companies. In this analysis, Air China's ROCE appears meaningfully below the 9.9% average reported by the Airlines industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Aside from the industry comparison, Air China's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Readers may find more attractive investment prospects elsewhere.
Air China's current ROCE of 6.6% is lower than 3 years ago, when the company reported a 9.4% ROCE. So investors might consider if it has had issues recently. You can see in the image below how Air China's ROCE compares to its industry. Click to see more on past growth.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. 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. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Air China.