Today we’ll evaluate SH Group (Holdings) Limited (HKG:1637) to determine whether it could have potential as an investment idea. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
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.
Return On Capital Employed (ROCE): What is it?
ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. Ultimately, it is a useful but imperfect metric. 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 SH Group (Holdings):
0.16 = HK$39m ÷ (HK$402m – HK$149m) (Based on the trailing twelve months to September 2019.)
Therefore, SH Group (Holdings) has an ROCE of 16%.
Does SH Group (Holdings) Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. SH Group (Holdings)’s ROCE appears to be substantially greater than the 12% average in the Construction 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. Independently of how SH Group (Holdings) compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
SH Group (Holdings)’s current ROCE of 16% is lower than its ROCE in the past, which was 24%, 3 years ago. This makes us wonder if the business is facing new challenges. The image below shows how SH Group (Holdings)’s ROCE compares to its industry, and you can click it to see more detail on its 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. How cyclical is SH Group (Holdings)? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
How SH Group (Holdings)’s Current Liabilities Impact 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 the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counteract this, we check if a company has high current liabilities, relative to its total assets.
SH Group (Holdings) has current liabilities of HK$149m and total assets of HK$402m. Therefore its current liabilities are equivalent to approximately 37% of its total assets. SH Group (Holdings) has a medium level of current liabilities, which would boost the ROCE.
What We Can Learn From SH Group (Holdings)’s ROCE
With a decent ROCE, the company could be interesting, but remember that the level of current liabilities make the ROCE look better. SH Group (Holdings) looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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