Some Investors May Be Worried About Design Capital's (HKG:1545) Returns On Capital

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? 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. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. However, after investigating Design Capital (HKG:1545), we don't think it's current trends fit the mold of a multi-bagger.

Understanding 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 Design Capital:

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

0.08 = S$5.5m ÷ (S$102m - S$34m) (Based on the trailing twelve months to June 2022).

Therefore, Design Capital has an ROCE of 8.0%. In absolute terms, that's a low return, but it's much better than the Trade Distributors industry average of 5.5%.

See our latest analysis for Design Capital

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 want to delve into the historical earnings, revenue and cash flow of Design Capital, check out these free graphs here.

How Are Returns Trending?

On the surface, the trend of ROCE at Design Capital doesn't inspire confidence. Over the last five years, returns on capital have decreased to 8.0% from 31% five years ago. 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, Design Capital has done well to pay down its current liabilities to 33% 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.

The Key Takeaway

From the above analysis, we find it rather worrisome that returns on capital and sales for Design Capital have fallen, meanwhile the business is employing more capital than it was five years ago. Investors must expect better things on the horizon though because the stock has risen 7.2% in the last three years. Regardless, we don't like the trends as they are and if they persist, we think you might find better investments elsewhere.

Since virtually every company faces some risks, it's worth knowing what they are, and we've spotted 5 warning signs for Design Capital (of which 2 don't sit too well with us!) that you should know about.

While Design Capital 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.