Should You Like Prosperous Industrial (Holdings) Limited’s (HKG:1731) High Return On Capital Employed?

Today we'll evaluate Prosperous Industrial (Holdings) Limited (HKG:1731) to determine whether it could have potential as an investment idea. Specifically, we'll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.

First of all, we'll work out how to calculate ROCE. Second, we'll look at its ROCE compared to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its 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'.

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 Prosperous Industrial (Holdings):

0.13 = US$24m ÷ (US$165m - US$51m) (Based on the trailing twelve months to June 2018.)

Therefore, Prosperous Industrial (Holdings) has an ROCE of 13%.

See our latest analysis for Prosperous Industrial (Holdings)

Does Prosperous Industrial (Holdings) Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. Prosperous Industrial (Holdings)'s ROCE appears to be substantially greater than the 9.4% average in the Luxury 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. Independently of how Prosperous Industrial (Holdings) compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

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 deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is, after all, simply a snap shot of a single year. You can check if Prosperous Industrial (Holdings) has cyclical profits by looking at this freegraph of past earnings, revenue and cash flow.

Do Prosperous Industrial (Holdings)'s Current Liabilities Skew Its ROCE?

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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.

Prosperous Industrial (Holdings) has total assets of US$165m and current liabilities of US$51m. As a result, its current liabilities are equal to approximately 31% of its total assets. Prosperous Industrial (Holdings) has a middling amount of current liabilities, increasing its ROCE somewhat.

The Bottom Line On Prosperous Industrial (Holdings)'s ROCE

Prosperous Industrial (Holdings)'s ROCE does look good, but the level of current liabilities also contribute to that. But note: Prosperous Industrial (Holdings) may not be the best stock to buy. So take a peek at this freelist of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

If you like to buy stocks alongside management, then you might just love this freelist of companies. (Hint: insiders have been buying them).

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.

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article 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.