Why Zhengye International Holdings Company Limited’s (HKG:3363) Return On Capital Employed Is Impressive

Today we are going to look at Zhengye International Holdings Company Limited (HKG:3363) to see whether it might be an attractive investment prospect. In particular, we’ll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

First, we’ll go over how we calculate ROCE. Next, we’ll compare it to others in its industry. Then we’ll determine how its current liabilities are affecting its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. All else being equal, a better business will have a higher ROCE. Ultimately, it is a useful but imperfect metric. Renowned investment researcher Michael Mauboussin has suggested that a high ROCE can indicate that ‘one dollar invested in the company generates value of more than one dollar’.

So, How Do We Calculate ROCE?

Analysts use this formula to calculate return on capital employed:

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

Or for Zhengye International Holdings:

0.19 = CN¥269m ÷ (CN¥2.7b – CN¥1.5b) (Based on the trailing twelve months to June 2018.)

So, Zhengye International Holdings has an ROCE of 19%.

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Is Zhengye International Holdings’s ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. Zhengye International Holdings’s ROCE appears to be substantially greater than the 13% average in the Packaging industry. I think that’s good to see, since it implies the company is better than other companies at making the most of its capital. Regardless of where Zhengye International Holdings sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.

In our analysis, Zhengye International Holdings’s ROCE appears to be 19%, compared to 3 years ago, when its ROCE was 11%. This makes us think the business might be improving.

SEHK:3363 Last Perf January 22nd 19
SEHK:3363 Last Perf January 22nd 19

It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is only a point-in-time measure. How cyclical is Zhengye International Holdings? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

How Zhengye International Holdings’s Current Liabilities Impact Its ROCE

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counteract this, we check if a company has high current liabilities, relative to its total assets.

Zhengye International Holdings has total liabilities of CN¥1.5b and total assets of CN¥2.7b. As a result, its current liabilities are equal to approximately 56% of its total assets. This is admittedly a high level of current liabilities, improving ROCE substantially.

What We Can Learn From Zhengye International Holdings’s ROCE

The ROCE would not look as appealing if the company had fewer current liabilities. You might be able to find a better buy than Zhengye International Holdings. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

I will like Zhengye International Holdings better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.