Here's What To Make Of China Tobacco International (HK)'s (HKG:6055) Returns On Capital

What trends should we look for it we want to identify stocks that can multiply in value over the long term? 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. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. However, after briefly looking over the numbers, we don't think China Tobacco International (HK) (HKG:6055) 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)?

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. To calculate this metric for China Tobacco International (HK), this is the formula:

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

0.045 = HK$72m ÷ (HK$3.6b - HK$2.0b) (Based on the trailing twelve months to December 2020).

Thus, China Tobacco International (HK) has an ROCE of 4.5%. In absolute terms, that's a low return but it's around the Retail Distributors industry average of 4.9%.

Check out our latest analysis for China Tobacco International (HK)

In the above chart we have measured China Tobacco International (HK)'s prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering China Tobacco International (HK) here for free.

What Does the ROCE Trend For China Tobacco International (HK) Tell Us?

When we looked at the ROCE trend at China Tobacco International (HK), we didn't gain much confidence. Around five years ago the returns on capital were 41%, but since then they've fallen to 4.5%. 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.

Another thing to note, China Tobacco International (HK) has a high ratio of current liabilities to total assets of 56%. This can bring about some risks because the company is basically operating with a rather large reliance on its suppliers or other sorts of short-term creditors. While it's not necessarily a bad thing, it can be beneficial if this ratio is lower.

The Key Takeaway

In summary, we're somewhat concerned by China Tobacco International (HK)'s diminishing returns on increasing amounts of capital. Yet despite these concerning fundamentals, the stock has performed strongly with a 17% return over the last year, so investors appear very optimistic. In any case, the current underlying trends don't bode well for long term performance so unless they reverse, we'd start looking elsewhere.

China Tobacco International (HK) does have some risks though, and we've spotted 1 warning sign for China Tobacco International (HK) that you might be interested in.

While China Tobacco International (HK) isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

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This article by Simply Wall St is general in nature. 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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