Our Take On The Returns On Capital At Tencent Holdings (HKG:700)

There are a few key trends to look for if we want to identify the next multi-bagger. One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing 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. However, after briefly looking over the numbers, we don't think Tencent Holdings (HKG:700) has the makings of a multi-bagger going forward, but let's have a look at why that may be.

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. To calculate this metric for Tencent Holdings, this is the formula:

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

0.13 = CN¥119b ÷ (CN¥1.2t - CN¥259b) (Based on the trailing twelve months to September 2020).

So, Tencent Holdings has an ROCE of 13%. That's a pretty standard return and it's in line with the industry average of 13%.

View our latest analysis for Tencent Holdings

Above you can see how the current ROCE for Tencent Holdings 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 Tencent Holdings Tell Us?

When we looked at the ROCE trend at Tencent Holdings, we didn't gain much confidence. To be more specific, ROCE has fallen from 20% over the last five years. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.

On a side note, Tencent Holdings has done well to pay down its current liabilities to 22% of total assets. That could partly explain why the ROCE has dropped. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. 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 Tencent Holdings' ROCE

In summary, despite lower returns in the short term, we're encouraged to see that Tencent Holdings is reinvesting for growth and has higher sales as a result. And the stock has done incredibly well with a 320% return over the last five years, so long term investors are no doubt ecstatic with that result. So while the underlying trends could already be accounted for by investors, we still think this stock is worth looking into further.

On a final note, we've found 2 warning signs for Tencent Holdings that we think 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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