Essence Fastening Systems (Shanghai) (SZSE:301005) May Have Issues Allocating Its Capital

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. However, after investigating Essence Fastening Systems (Shanghai) (SZSE:301005), we don't think it's current trends fit the mold of a multi-bagger.

What Is Return On Capital Employed (ROCE)?

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Analysts use this formula to calculate it for Essence Fastening Systems (Shanghai):

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.024 = CN¥21m ÷ (CN¥1.1b - CN¥253m) (Based on the trailing twelve months to September 2023).

Thus, Essence Fastening Systems (Shanghai) has an ROCE of 2.4%. Ultimately, that's a low return and it under-performs the Auto Components industry average of 6.6%.

View our latest analysis for Essence Fastening Systems (Shanghai)

Historical performance is a great place to start when researching a stock so above you can see the gauge for Essence Fastening Systems (Shanghai)'s ROCE against it's prior returns. If you'd like to look at how Essence Fastening Systems (Shanghai) has performed in the past in other metrics, you can view this free graph of Essence Fastening Systems (Shanghai)'s past earnings, revenue and cash flow.

How Are Returns Trending?

On the surface, the trend of ROCE at Essence Fastening Systems (Shanghai) doesn't inspire confidence. Around five years ago the returns on capital were 26%, but since then they've fallen to 2.4%. Meanwhile, the business is utilizing more capital but this hasn't moved the needle much in terms of sales in the past 12 months, so this could reflect longer term investments. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.

On a side note, Essence Fastening Systems (Shanghai) has done well to pay down its current liabilities to 23% of total assets. That could partly explain why the ROCE has dropped. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.

Our Take On Essence Fastening Systems (Shanghai)'s ROCE

Bringing it all together, while we're somewhat encouraged by Essence Fastening Systems (Shanghai)'s reinvestment in its own business, we're aware that returns are shrinking. Since the stock has gained an impressive 21% over the last year, investors must think there's better things to come. Ultimately, if the underlying trends persist, we wouldn't hold our breath on it being a multi-bagger going forward.

If you want to know some of the risks facing Essence Fastening Systems (Shanghai) we've found 4 warning signs (1 can't be ignored!) that you should be aware of before investing here.

While Essence Fastening Systems (Shanghai) isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.