Why We’re Not Keen On China Chengtong Development Group Limited’s (HKG:217) 0.3% Return On Capital

Today we’ll evaluate China Chengtong Development Group Limited (HKG:217) to determine whether it could have potential as an investment idea. In particular, we’ll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

First, we’ll go over how we calculate ROCE. Then we’ll compare its ROCE to similar companies. Then we’ll determine how its current liabilities are affecting its ROCE.

Understanding 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. In general, businesses with a higher ROCE are usually better quality. Ultimately, it is a useful but imperfect metric. 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 China Chengtong Development Group:

0.0035 = HK$12m ÷ (HK$3.6b – HK$527m) (Based on the trailing twelve months to June 2018.)

So, China Chengtong Development Group has an ROCE of 0.3%.

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Is China Chengtong Development Group’s ROCE Good?

One way to assess ROCE is to compare similar companies. Using our data, China Chengtong Development Group’s ROCE appears to be significantly below the 6.0% average in the Trade Distributors industry. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Putting aside China Chengtong Development Group’s performance relative to its industry, its ROCE in absolute terms is poor – considering the risk of owning stocks compared to government bonds. It is likely that there are more attractive prospects out there.

China Chengtong Development Group delivered an ROCE of 0.3%, which is better than 3 years ago, as was making losses back then. That suggests the business has returned to profitability.

SEHK:217 Last Perf January 30th 19
SEHK:217 Last Perf January 30th 19

When considering ROCE, bear in mind that it reflects the past and does not necessarily 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 only a point-in-time measure. How cyclical is China Chengtong Development Group? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

What Are Current Liabilities, And How Do They Affect China Chengtong Development Group’s ROCE?

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counteract this, we check if a company has high current liabilities, relative to its total assets.

China Chengtong Development Group has total assets of HK$3.6b and current liabilities of HK$527m. As a result, its current liabilities are equal to approximately 15% of its total assets. This is a modest level of current liabilities, which will have a limited impact on the ROCE.

The Bottom Line On China Chengtong Development Group’s ROCE

That’s not a bad thing, however China Chengtong Development Group has a weak ROCE and may not be an attractive investment. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.