Did you know there are some financial metrics that can provide clues of a potential multi-bagger? Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. 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 HongGuang Lighting Holdings (HKG:6908), we don't think it's current trends fit the mold of a multi-bagger.
Return On Capital Employed (ROCE): What is it?
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. To calculate this metric for HongGuang Lighting Holdings, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.10 = CN¥18m ÷ (CN¥203m - CN¥34m) (Based on the trailing twelve months to June 2020).
So, HongGuang Lighting Holdings has an ROCE of 10%. In absolute terms, that's a satisfactory return, but compared to the Semiconductor industry average of 7.6% it's much better.
Historical performance is a great place to start when researching a stock so above you can see the gauge for HongGuang Lighting Holdings' ROCE against it's prior returns. If you want to delve into the historical earnings, revenue and cash flow of HongGuang Lighting Holdings, check out these free graphs here.
What The Trend Of ROCE Can Tell Us
On the surface, the trend of ROCE at HongGuang Lighting Holdings doesn't inspire confidence. Over the last five years, returns on capital have decreased to 10% from 28% five years ago. 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, HongGuang Lighting Holdings has decreased its current liabilities to 17% 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.
The Bottom Line On HongGuang Lighting Holdings' ROCE
In summary, we're somewhat concerned by HongGuang Lighting Holdings' diminishing returns on increasing amounts of capital. Investors must expect better things on the horizon though because the stock has risen 20% in the last three years. Regardless, we don't like the trends as they are and if they persist, we think you might find better investments elsewhere.
If you'd like to know more about HongGuang Lighting Holdings, we've spotted 3 warning signs, and 1 of them is significant.
While HongGuang Lighting 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. 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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