If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Amongst other things, we'll want to see two things; firstly, a growing return on capital employed (ROCE) and secondly, an expansion in the company's amount of capital employed. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. Speaking of which, we noticed some great changes in Honghua Group's (HKG:196) returns on capital, so let's have a look.
What is Return On Capital Employed (ROCE)?
Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. The formula for this calculation on Honghua Group is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.042 = CN¥288m ÷ (CN¥12b - CN¥5.2b) (Based on the trailing twelve months to December 2020).
Thus, Honghua Group has an ROCE of 4.2%. On its own that's a low return on capital but it's in line with the industry's average returns of 4.2%.
In the above chart we have measured Honghua Group's prior ROCE against its prior performance, but the future is arguably more important. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Honghua Group.
How Are Returns Trending?
We're delighted to see that Honghua Group is reaping rewards from its investments and has now broken into profitability. While the business was unprofitable in the past, it's now turned things around and is earning 4.2% on its capital. While returns have increased, the amount of capital employed by Honghua Group has remained flat over the period. With no noticeable increase in capital employed, it's worth knowing what the company plans on doing going forward in regards to reinvesting and growing the business. So if you're looking for high growth, you'll want to see a business's capital employed also increasing.
On a side note, Honghua Group's current liabilities are still rather high at 43% of total assets. This can bring about some risks because the company is basically operating with a rather large reliance on its suppliers or other sorts of short-term creditors. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.
What We Can Learn From Honghua Group's ROCE
As discussed above, Honghua Group appears to be getting more proficient at generating returns since capital employed has remained flat but earnings (before interest and tax) are up. Given the stock has declined 26% in the last five years, this could be a good investment if the valuation and other metrics are also appealing. That being the case, research into the company's current valuation metrics and future prospects seems fitting.
On a final note, we found 4 warning signs for Honghua Group (1 is significant) you should be aware of.
If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive returns on equity.
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