What are the early trends we should look for to identify a stock that could multiply in value over the long term? 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. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. Although, when we looked at Wai Chi Holdings (HKG:1305), it didn't seem to tick all of these boxes.
Return On Capital Employed (ROCE): What is it?
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 Wai Chi Holdings, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.042 = HK$33m ÷ (HK$2.0b - HK$1.2b) (Based on the trailing twelve months to December 2020).
Therefore, Wai Chi Holdings has an ROCE of 4.2%. In absolute terms, that's a low return and it also under-performs the Semiconductor industry average of 7.3%.
While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you'd like to look at how Wai Chi Holdings has performed in the past in other metrics, you can view this free graph of past earnings, revenue and cash flow.
What Does the ROCE Trend For Wai Chi Holdings Tell Us?
When we looked at the ROCE trend at Wai Chi Holdings, we didn't gain much confidence. Around five years ago the returns on capital were 6.1%, but since then they've fallen to 4.2%. And considering revenue has dropped while employing more capital, we'd be cautious. This could mean that the business is losing its competitive advantage or market share, because while more money is being put into ventures, it's actually producing a lower return - "less bang for their buck" per se.
On a side note, Wai Chi Holdings' current liabilities are still rather high at 61% of total assets. 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.
What We Can Learn From Wai Chi Holdings' ROCE
We're a bit apprehensive about Wai Chi Holdings because despite more capital being deployed in the business, returns on that capital and sales have both fallen. It should come as no surprise then that the stock has fallen 61% over the last five years, so it looks like investors are recognizing these changes. With underlying trends that aren't great in these areas, we'd consider looking elsewhere.
Wai Chi Holdings does come with some risks though, we found 3 warning signs in our investment analysis, and 1 of those shouldn't be ignored...
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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