Shandong Hualu-Hengsheng Chemical (SHSE:600426) May Have Issues Allocating Its Capital

Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. However, after investigating Shandong Hualu-Hengsheng Chemical (SHSE:600426), we don't think it's current trends fit the mold of a multi-bagger.

Return On Capital Employed (ROCE): What Is It?

Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. To calculate this metric for Shandong Hualu-Hengsheng Chemical, this is the formula:

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

0.12 = CN¥4.5b ÷ (CN¥44b - CN¥5.8b) (Based on the trailing twelve months to December 2023).

Therefore, Shandong Hualu-Hengsheng Chemical has an ROCE of 12%. In absolute terms, that's a satisfactory return, but compared to the Chemicals industry average of 6.0% it's much better.

View our latest analysis for Shandong Hualu-Hengsheng Chemical

Above you can see how the current ROCE for Shandong Hualu-Hengsheng Chemical compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Shandong Hualu-Hengsheng Chemical for free.

So How Is Shandong Hualu-Hengsheng Chemical's ROCE Trending?

When we looked at the ROCE trend at Shandong Hualu-Hengsheng Chemical, we didn't gain much confidence. Over the last five years, returns on capital have decreased to 12% from 26% five years ago. 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.

In Conclusion...

Bringing it all together, while we're somewhat encouraged by Shandong Hualu-Hengsheng Chemical's reinvestment in its own business, we're aware that returns are shrinking. Investors must think there's better things to come because the stock has knocked it out of the park, delivering a 151% gain to shareholders who have held over the last five years. But if the trajectory of these underlying trends continue, we think the likelihood of it being a multi-bagger from here isn't high.

Shandong Hualu-Hengsheng Chemical does come with some risks though, we found 3 warning signs in our investment analysis, and 1 of those makes us a bit uncomfortable...

For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.

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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.