China MeiDong Auto Holdings (HKG:1268) Could Be Struggling To Allocate Capital

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? 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. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. Having said that, from a first glance at China MeiDong Auto Holdings (HKG:1268) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.

What Is Return On Capital Employed (ROCE)?

For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. The formula for this calculation on China MeiDong Auto Holdings is:

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

0.17 = CN¥1.6b ÷ (CN¥17b - CN¥7.4b) (Based on the trailing twelve months to June 2022).

Therefore, China MeiDong Auto Holdings has an ROCE of 17%. On its own, that's a standard return, however it's much better than the 11% generated by the Specialty Retail industry.

View our latest analysis for China MeiDong Auto Holdings

Above you can see how the current ROCE for China MeiDong Auto 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 China MeiDong Auto Holdings Tell Us?

In terms of China MeiDong Auto Holdings' historical ROCE movements, the trend isn't fantastic. To be more specific, ROCE has fallen from 30% over the last five years. However it looks like China MeiDong Auto Holdings might be reinvesting for long term growth because while capital employed has increased, the company's sales haven't changed much in the last 12 months. It may take some time before the company starts to see any change in earnings from these investments.

On a related note, China MeiDong Auto Holdings has decreased its current liabilities to 44% of total assets. So we could link some of this to the decrease in ROCE. 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. Keep in mind 44% is still pretty high, so those risks are still somewhat prevalent.

What We Can Learn From China MeiDong Auto Holdings' ROCE

To conclude, we've found that China MeiDong Auto Holdings is reinvesting in the business, but returns have been falling. Yet to long term shareholders the stock has gifted them an incredible 718% return in the last five years, so the market appears to be rosy about its future. However, unless these underlying trends turn more positive, we wouldn't get our hopes up too high.

One more thing to note, we've identified 3 warning signs with China MeiDong Auto Holdings and understanding them should be part of your investment process.

While China MeiDong Auto Holdings 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.