Are REF Holdings Limited’s (HKG:1631) High Returns Really That Great?

Today we are going to look at REF Holdings Limited (HKG:1631) to see whether it might be an attractive investment prospect. 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.

Firstly, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect 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. Overall, it is a valuable metric that has its flaws. 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?

Analysts use this formula to calculate return on capital employed:

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

Or for REF Holdings:

0.17 = HK$41m ÷ (HK$321m - HK$77m) (Based on the trailing twelve months to June 2019.)

Therefore, REF Holdings has an ROCE of 17%.

See our latest analysis for REF Holdings

Is REF Holdings's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. REF Holdings's ROCE appears to be substantially greater than the 10% average in the Commercial Services industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Separate from REF Holdings's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.

We can see that, REF Holdings currently has an ROCE of 17%, less than the 63% it reported 3 years ago. Therefore we wonder if the company is facing new headwinds. You can click on the image below to see (in greater detail) how REF Holdings's past growth compares to other companies.

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. You can check if REF Holdings has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.

What Are Current Liabilities, And How Do They Affect REF Holdings's ROCE?

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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 counter this, investors can check if a company has high current liabilities relative to total assets.

REF Holdings has total assets of HK$321m and current liabilities of HK$77m. As a result, its current liabilities are equal to approximately 24% of its total assets. A fairly low level of current liabilities is not influencing the ROCE too much.

The Bottom Line On REF Holdings's ROCE

This is good to see, and with a sound ROCE, REF Holdings could be worth a closer look. REF Holdings looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.

I will like REF Holdings better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider 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.