Here's What We Make Of Fountain Set (Holdings)'s (HKG:420) Returns On Capital

To avoid investing in a business that's in decline, there's a few financial metrics that can provide early indications of aging. A business that's potentially in decline often shows two trends, a return on capital employed (ROCE) that's declining, and a base of capital employed that's also declining. Basically the company is earning less on its investments and it is also reducing its total assets. So after we looked into Fountain Set (Holdings) (HKG:420), the trends above didn't look too great.

What is Return On Capital Employed (ROCE)?

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. The formula for this calculation on Fountain Set (Holdings) is:

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

0.032 = HK$119m ÷ (HK$5.0b - HK$1.3b) (Based on the trailing twelve months to June 2020).

So, Fountain Set (Holdings) has an ROCE of 3.2%. In absolute terms, that's a low return and it also under-performs the Luxury industry average of 9.2%.

View our latest analysis for Fountain Set (Holdings)

While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you want to delve into the historical earnings, revenue and cash flow of Fountain Set (Holdings), check out these free graphs here.

The Trend Of ROCE

There is reason to be cautious about Fountain Set (Holdings), given the returns are trending downwards. Unfortunately the returns on capital have diminished from the 5.4% that they were earning five years ago. On top of that, it's worth noting that the amount of capital employed within the business has remained relatively steady. Since returns are falling and the business has the same amount of assets employed, this can suggest it's a mature business that hasn't had much growth in the last five years. If these trends continue, we wouldn't expect Fountain Set (Holdings) to turn into a multi-bagger.

On a side note, Fountain Set (Holdings) has done well to pay down its current liabilities to 26% 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.

What We Can Learn From Fountain Set (Holdings)'s ROCE

In the end, the trend of lower returns on the same amount of capital isn't typically an indication that we're looking at a growth stock. Yet despite these concerning fundamentals, the stock has performed strongly with a 48% return over the last five years, so investors appear very optimistic. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.

On a separate note, we've found 2 warning signs for Fountain Set (Holdings) you'll probably want to know about.

While Fountain Set (Holdings) may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.

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