China Hongguang Holdings (HKG:8646) Is Reinvesting At Lower Rates Of Return

Did you know there are some financial metrics that can provide clues of a potential multi-bagger? Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base 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. Having said that, while the ROCE is currently high for China Hongguang Holdings (HKG:8646), we aren't jumping out of our chairs because returns are decreasing.

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. Analysts use this formula to calculate it for China Hongguang Holdings:

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

0.22 = CN¥49m ÷ (CN¥327m - CN¥107m) (Based on the trailing twelve months to September 2022).

Therefore, China Hongguang Holdings has an ROCE of 22%. That's a fantastic return and not only that, it outpaces the average of 12% earned by companies in a similar industry.

See our latest analysis for China Hongguang Holdings

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

How Are Returns Trending?

In terms of China Hongguang Holdings' historical ROCE movements, the trend isn't fantastic. While it's comforting that the ROCE is high, four years ago it was 48%. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.

On a side note, China Hongguang Holdings 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. 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 China Hongguang Holdings' ROCE

In summary, despite lower returns in the short term, we're encouraged to see that China Hongguang Holdings is reinvesting for growth and has higher sales as a result. Furthermore the stock has climbed 54% over the last year, it would appear that investors are upbeat about the future. So while the underlying trends could already be accounted for by investors, we still think this stock is worth looking into further.

China Hongguang Holdings does have some risks though, and we've spotted 2 warning signs for China Hongguang Holdings that you might be interested in.

If you'd like to see other companies earning high returns, check out our free list of companies earning high returns with solid balance sheets here.

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.