Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. In a perfect world, we'd like to see a company investing more capital into its business and ideally the returns earned from that capital are also increasing. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. However, after investigating Tencent Holdings (HKG:700), we don't think it's current trends fit the mold of a multi-bagger.
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. Analysts use this formula to calculate it for Tencent Holdings:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.11 = CN¥131b ÷ (CN¥1.5t - CN¥278b) (Based on the trailing twelve months to June 2021).
Therefore, Tencent Holdings has an ROCE of 11%. In absolute terms, that's a satisfactory return, but compared to the Interactive Media and Services industry average of 7.0% it's much better.
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.
So How Is Tencent Holdings' ROCE Trending?
In terms of Tencent Holdings' historical ROCE movements, the trend isn't fantastic. Over the last five years, returns on capital have decreased to 11% from 20% five years ago. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. 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 18% 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.
Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Tencent Holdings. And long term investors must be optimistic going forward because the stock has returned a huge 135% to shareholders in the last five years. So should these growth trends continue, we'd be optimistic on the stock going forward.
On a separate note, we've found 2 warning signs for Tencent Holdings you'll probably want to know about.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
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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