SMC Electric (HKG:2381) May Have Issues Allocating Its Capital

What are the early trends we should look for to identify a stock that could multiply in value over the long term? One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing amount of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. Looking at SMC Electric (HKG:2381), it does have a high ROCE right now, but lets see how returns are trending.

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 SMC Electric, this is the formula:

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

0.24 = HK$45m ÷ (HK$245m - HK$57m) (Based on the trailing twelve months to June 2022).

Therefore, SMC Electric has an ROCE of 24%. In absolute terms that's a great return and it's even better than the Consumer Durables industry average of 11%.

See our latest analysis for SMC Electric

Historical performance is a great place to start when researching a stock so above you can see the gauge for SMC Electric's ROCE against it's prior returns. If you want to delve into the historical earnings, revenue and cash flow of SMC Electric, check out these free graphs here.

So How Is SMC Electric's ROCE Trending?

When we looked at the ROCE trend at SMC Electric, we didn't gain much confidence. To be more specific, while the ROCE is still high, it's fallen from 41% where it was five years ago. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. If these investments prove successful, this can bode very well for long term stock performance.

On a related note, SMC Electric has decreased its current liabilities to 23% of total assets. So we could link some of this to the decrease in ROCE. 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. 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

Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for SMC Electric. Furthermore the stock has climbed 7.7% over the last year, it would appear that investors are upbeat about the future. So while investors seem to be recognizing these promising trends, we would look further into this stock to make sure the other metrics justify the positive view.

One more thing: We've identified 4 warning signs with SMC Electric (at least 3 which make us uncomfortable) , and understanding them would certainly be useful.

If you want to search for more stocks that have been earning high returns, check out this free list of stocks with solid balance sheets that are also earning high returns on equity.

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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.