China Hongguang Holdings' (HKG:8646) Returns On Capital Not Reflecting Well On The Business

If you're looking for a multi-bagger, there's a few things to keep an eye out for. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. However, after briefly looking over the numbers, we don't think China Hongguang Holdings (HKG:8646) has the makings of a multi-bagger going forward, but let's have a look at why that may be.

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 China Hongguang Holdings, this is the formula:

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

0.09 = CN¥16m ÷ (CN¥270m - CN¥88m) (Based on the trailing twelve months to September 2021).

So, China Hongguang Holdings has an ROCE of 9.0%. Ultimately, that's a low return and it under-performs the Building industry average of 16%.

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're interested in investigating China Hongguang Holdings' past further, check out this free graph of past earnings, revenue and cash flow.

So How Is China Hongguang Holdings' ROCE Trending?

On the surface, the trend of ROCE at China Hongguang Holdings doesn't inspire confidence. Around three years ago the returns on capital were 48%, but since then they've fallen to 9.0%. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It may take some time before the company starts to see any change in earnings from these investments.

On a related note, China Hongguang Holdings has decreased its current liabilities to 32% of total assets. That could partly explain why the ROCE has dropped. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. 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.

Our Take On China Hongguang Holdings' ROCE

Bringing it all together, while we're somewhat encouraged by China Hongguang Holdings' reinvestment in its own business, we're aware that returns are shrinking. Since the stock has gained an impressive 23% over the last year, investors must think there's better things to come. But if the trajectory of these underlying trends continue, we think the likelihood of it being a multi-bagger from here isn't high.

If you want to know some of the risks facing China Hongguang Holdings we've found 4 warning signs (1 shouldn't be ignored!) that you should be aware of before investing here.

While China Hongguang Holdings isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

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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.