Today we’ll evaluate CGN Power Co., Ltd. (HKG:1816) 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.
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. Finally, we’ll look at how its current liabilities affect its ROCE.
Return On Capital Employed (ROCE): What is it?
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. 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’.
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 CGN Power:
0.07 = CN¥23b ÷ (CN¥396b – CN¥72b) (Based on the trailing twelve months to September 2019.)
So, CGN Power has an ROCE of 7.0%.
Does CGN Power Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. We can see CGN Power’s ROCE is around the 7.1% average reported by the Renewable Energy industry. Setting aside the industry comparison for now, CGN Power’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.
In our analysis, CGN Power’s ROCE appears to be 7.0%, compared to 3 years ago, when its ROCE was 5.1%. This makes us think the business might be improving. You can click on the image below to see (in greater detail) how CGN Power’s past growth compares to other companies.
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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
How CGN Power’s Current Liabilities Impact Its ROCE
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
CGN Power has total assets of CN¥396b and current liabilities of CN¥72b. Therefore its current liabilities are equivalent to approximately 18% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.
What We Can Learn From CGN Power’s ROCE
That said, CGN Power’s ROCE is mediocre, there may be more attractive investments around. You might be able to find a better investment than CGN Power. 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).
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.
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. Thank you for reading.