Today we’ll evaluate Guangdong Adway Construction (Group) Holdings Company Limited (HKG:6189) 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.
First, 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.
What is Return On Capital Employed (ROCE)?
ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the 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’.
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 Guangdong Adway Construction (Group) Holdings:
0.18 = CN¥200m ÷ (CN¥2.7b – CN¥1.6b) (Based on the trailing twelve months to June 2019.)
So, Guangdong Adway Construction (Group) Holdings has an ROCE of 18%.
Is Guangdong Adway Construction (Group) Holdings’s ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. Using our data, we find that Guangdong Adway Construction (Group) Holdings’s ROCE is meaningfully better than the 12% average in the Construction industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Regardless of where Guangdong Adway Construction (Group) Holdings sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
We can see that, Guangdong Adway Construction (Group) Holdings currently has an ROCE of 18%, less than the 26% it reported 3 years ago. Therefore we wonder if the company is facing new headwinds. The image below shows how Guangdong Adway Construction (Group) Holdings’s ROCE compares to its industry, and you can click it to see more detail on its past growth.
Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately predict the future. 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. How cyclical is Guangdong Adway Construction (Group) Holdings? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
Do Guangdong Adway Construction (Group) Holdings’s Current Liabilities Skew 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 ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counter this, investors can check if a company has high current liabilities relative to total assets.
Guangdong Adway Construction (Group) Holdings has total assets of CN¥2.7b and current liabilities of CN¥1.6b. Therefore its current liabilities are equivalent to approximately 58% of its total assets. This is admittedly a high level of current liabilities, improving ROCE substantially.
The Bottom Line On Guangdong Adway Construction (Group) Holdings’s ROCE
This ROCE is pretty good, but remember that it would look less impressive with fewer current liabilities. There might be better investments than Guangdong Adway Construction (Group) Holdings out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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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