Be Wary Of Guan Chao Holdings (HKG:1872) And Its Returns On Capital

If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. However, after investigating Guan Chao Holdings (HKG:1872), we don't think it's current trends fit the mold of a multi-bagger.

What is Return On Capital Employed (ROCE)?

For those that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. Analysts use this formula to calculate it for Guan Chao Holdings:

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

0.064 = S$5.0m ÷ (S$111m - S$32m) (Based on the trailing twelve months to December 2020).

So, Guan Chao Holdings has an ROCE of 6.4%. In absolute terms, that's a low return and it also under-performs the Specialty Retail industry average of 11%.

Check out our latest analysis for Guan Chao Holdings

Historical performance is a great place to start when researching a stock so above you can see the gauge for Guan Chao Holdings' ROCE against it's prior returns. If you want to delve into the historical earnings, revenue and cash flow of Guan Chao Holdings, check out these free graphs here.

How Are Returns Trending?

In terms of Guan Chao Holdings' historical ROCE movements, the trend isn't fantastic. Around five years ago the returns on capital were 44%, but since then they've fallen to 6.4%. Given the business is employing more capital while revenue has slipped, this is a bit concerning. If this were to continue, you might be looking at a company that is trying to reinvest for growth but is actually losing market share since sales haven't increased.

On a related note, Guan Chao Holdings has decreased its current liabilities to 29% 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. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.

What We Can Learn From Guan Chao Holdings' ROCE

We're a bit apprehensive about Guan Chao Holdings because despite more capital being deployed in the business, returns on that capital and sales have both fallen. But investors must be expecting an improvement of sorts because over the last yearthe stock has delivered a respectable 44% return. In any case, the current underlying trends don't bode well for long term performance so unless they reverse, we'd start looking elsewhere.

Since virtually every company faces some risks, it's worth knowing what they are, and we've spotted 4 warning signs for Guan Chao Holdings (of which 2 can't be ignored!) that you should 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.

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