Today we are going to look at Tree Holdings Limited (HKG:8395) to see whether it might be an attractive investment prospect. 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.
First up, we’ll look at what ROCE is and how we calculate it. Next, we’ll compare it to others in its industry. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.
What is 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. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.
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 Tree Holdings:
0.063 = HK$5.6m ÷ (HK$115m – HK$26m) (Based on the trailing twelve months to September 2019.)
Therefore, Tree Holdings has an ROCE of 6.3%.
Is Tree Holdings’s ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, Tree Holdings’s ROCE appears to be around the 6.3% average of the Retail Distributors industry. Aside from the industry comparison, Tree Holdings’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.
Tree Holdings’s current ROCE of 6.3% is lower than 3 years ago, when the company reported a 35% ROCE. So investors might consider if it has had issues recently. The image below shows how Tree Holdings’s ROCE compares to its industry, and you can click it to see more detail on its past growth.
When considering this metric, keep in mind that it is backwards looking, and 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. How cyclical is Tree Holdings? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
Tree Holdings’s Current Liabilities And Their Impact On 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. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Tree Holdings has total assets of HK$115m and current liabilities of HK$26m. As a result, its current liabilities are equal to approximately 22% of its total assets. It is good to see a restrained amount of current liabilities, as this limits the effect on ROCE.
What We Can Learn From Tree Holdings’s ROCE
If Tree Holdings continues to earn an uninspiring ROCE, there may be better places to invest. Of course, you might also be able to find a better stock than Tree Holdings. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
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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