Here’s What Datang Environment Industry Group Co., Ltd.’s (HKG:1272) Return On Capital Can Tell Us

Today we’ll evaluate Datang Environment Industry Group Co., Ltd. (HKG:1272) to determine whether it could have potential as an investment idea. To be precise, we’ll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

Firstly, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. Then we’ll determine how its current liabilities are affecting its ROCE.

Return On Capital Employed (ROCE): What is it?

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. All else being equal, a better business will have a higher ROCE. 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’.

So, How Do We Calculate ROCE?

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 Datang Environment Industry Group:

0.094 = CN¥968m ÷ (CN¥20b – CN¥10b) (Based on the trailing twelve months to December 2018.)

So, Datang Environment Industry Group has an ROCE of 9.4%.

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Does Datang Environment Industry Group Have A Good ROCE?

One way to assess ROCE is to compare similar companies. It appears that Datang Environment Industry Group’s ROCE is fairly close to the Commercial Services industry average of 10%. Separate from how Datang Environment Industry Group stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Readers may find more attractive investment prospects elsewhere.

As we can see, Datang Environment Industry Group currently has an ROCE of 9.4%, less than the 15% it reported 3 years ago. Therefore we wonder if the company is facing new headwinds.

SEHK:1272 Past Revenue and Net Income, May 17th 2019
SEHK:1272 Past Revenue and Net Income, May 17th 2019

Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately predict the future. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. If Datang Environment Industry Group is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.

What Are Current Liabilities, And How Do They Affect Datang Environment Industry Group’s ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To counteract this, we check if a company has high current liabilities, relative to its total assets.

Datang Environment Industry Group has total liabilities of CN¥10b and total assets of CN¥20b. Therefore its current liabilities are equivalent to approximately 50% of its total assets. Datang Environment Industry Group’s ROCE is improved somewhat by its moderate amount of current liabilities.

Our Take On Datang Environment Industry Group’s ROCE

Despite this, its ROCE is still mediocre, and you may find more appealing investments elsewhere. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.