Returns Are Gaining Momentum At Honghua Group (HKG:196)

If you're not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out for. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. So when we looked at Honghua Group (HKG:196) and its trend of ROCE, we really liked what we saw.

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. Analysts use this formula to calculate it for Honghua Group:

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%. In absolute terms, that's a low return and it also under-performs the Energy Services industry average of 7.1%.

Check out our latest analysis for Honghua Group

Above you can see how the current ROCE for Honghua Group compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

What Can We Tell From Honghua Group's ROCE Trend?

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. On top of that, what's interesting is that the amount of capital being employed has remained steady, so the business hasn't needed to put any additional money to work to generate these higher returns. 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. After all, a company can only become a long term multi-bagger if it continually reinvests in itself at high rates of return.

On a separate but related note, it's important to know that Honghua Group has a current liabilities to total assets ratio of 43%, which we'd consider pretty high. 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.

The Bottom Line

To bring it all together, Honghua Group has done well to increase the returns it's generating from its capital employed. Astute investors may have an opportunity here because the stock has declined 41% in the last five years. With that in mind, we believe the promising trends warrant this stock for further investigation.

Honghua Group does have some risks, we noticed 3 warning signs (and 1 which can't be ignored) we think you should know about.

While Honghua Group 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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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.
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