Investors Could Be Concerned With Shanghai Chemspec's (SHSE:688602) Returns On Capital

What are the early trends we should look for to identify a stock that could multiply in value over the long term? One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing 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 Shanghai Chemspec (SHSE:688602), we don't think it's current trends fit the mold of a multi-bagger.

Understanding Return On Capital Employed (ROCE)

For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. To calculate this metric for Shanghai Chemspec, this is the formula:

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

0.012 = CN¥35m ÷ (CN¥3.4b - CN¥408m) (Based on the trailing twelve months to March 2024).

Therefore, Shanghai Chemspec has an ROCE of 1.2%. Ultimately, that's a low return and it under-performs the Chemicals industry average of 5.6%.

Check out our latest analysis for Shanghai Chemspec

While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you're interested in investigating Shanghai Chemspec's past further, check out this free graph covering Shanghai Chemspec's past earnings, revenue and cash flow.

How Are Returns Trending?

On the surface, the trend of ROCE at Shanghai Chemspec doesn't inspire confidence. To be more specific, ROCE has fallen from 14% over the last five years. And considering revenue has dropped while employing more capital, we'd be cautious. This could mean that the business is losing its competitive advantage or market share, because while more money is being put into ventures, it's actually producing a lower return - "less bang for their buck" per se.

On a side note, Shanghai Chemspec has done well to pay down its current liabilities to 12% of total assets. So we could link some of this to the decrease in ROCE. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.

The Bottom Line On Shanghai Chemspec's ROCE

In summary, we're somewhat concerned by Shanghai Chemspec's diminishing returns on increasing amounts of capital. Investors haven't taken kindly to these developments, since the stock has declined 43% from where it was year ago. Unless there is a shift to a more positive trajectory in these metrics, we would look elsewhere.

If you want to know some of the risks facing Shanghai Chemspec we've found 3 warning signs (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

While Shanghai Chemspec may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.

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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.