What trends should we look for it we want to identify stocks that can multiply in value over the long term? 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. With that in mind, we've noticed some promising trends at Honghua Group (HKG:196) so let's look a bit deeper.
Return On Capital Employed (ROCE): What is it?
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)
0.038 = CN¥267m ÷ (CN¥12b - CN¥5.3b) (Based on the trailing twelve months to June 2020).
Thus, Honghua Group has an ROCE of 3.8%. In absolute terms, that's a low return and it also under-performs the Energy Services industry average of 11%.
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 Does the ROCE Trend For Honghua Group Tell Us?
Even though ROCE is still low in absolute terms, it's good to see it's heading in the right direction. More specifically, while the company has kept capital employed relatively flat over the last five years, the ROCE has climbed 174% in that same time. So it's likely that the business is now reaping the full benefits of its past investments, since the capital employed hasn't changed considerably. The company is doing well in that sense, and it's worth investigating what the management team has planned for long term growth prospects.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 effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.
To bring it all together, Honghua Group has done well to increase the returns it's generating from its capital employed. And since the stock has fallen 48% over the last five years, there might be an opportunity here. With that in mind, we believe the promising trends warrant this stock for further investigation.
If you want to know some of the risks facing Honghua Group we've found 3 warning signs (1 shouldn't be ignored!) that you should be aware of before investing here.
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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