MEGAIN Holding (Cayman) (HKG:6939) Could Be Struggling To Allocate Capital

What are the early trends we should look for to identify a stock that could multiply in value over the long term? 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 briefly looking over the numbers, we don't think MEGAIN Holding (Cayman) (HKG:6939) has the makings of a multi-bagger going forward, but let's have a look at why that may be.

Return On Capital Employed (ROCE): What Is It?

Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Analysts use this formula to calculate it for MEGAIN Holding (Cayman):

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

0.12 = CN¥40m ÷ (CN¥374m - CN¥34m) (Based on the trailing twelve months to June 2022).

So, MEGAIN Holding (Cayman) has an ROCE of 12%. In absolute terms, that's a pretty normal return, and it's somewhat close to the Semiconductor industry average of 14%.

Our analysis indicates that 6939 is potentially undervalued!

Historical performance is a great place to start when researching a stock so above you can see the gauge for MEGAIN Holding (Cayman)'s ROCE against it's prior returns. If you'd like to look at how MEGAIN Holding (Cayman) has performed in the past in other metrics, you can view this free graph of past earnings, revenue and cash flow.

What The Trend Of ROCE Can Tell Us

In terms of MEGAIN Holding (Cayman)'s historical ROCE movements, the trend isn't fantastic. To be more specific, ROCE has fallen from 53% over the last four years. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. And if the increased capital generates additional returns, the business, and thus shareholders, will benefit in the long run.

On a side note, MEGAIN Holding (Cayman) has done well to pay down its current liabilities to 9.1% 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. 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

In summary, despite lower returns in the short term, we're encouraged to see that MEGAIN Holding (Cayman) is reinvesting for growth and has higher sales as a result. However, despite the promising trends, the stock has fallen 50% over the last year, so there might be an opportunity here for astute investors. As a result, we'd recommend researching this stock further to uncover what other fundamentals of the business can show us.

On a final note, we found 4 warning signs for MEGAIN Holding (Cayman) (2 are significant) you should be aware of.

While MEGAIN Holding (Cayman) 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.