Returns On Capital At Digital China Holdings (HKG:861) Paint A Concerning Picture

There are a few key trends to look for if we want to identify the next multi-bagger. 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. 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 Digital China Holdings (HKG:861) 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 Digital China Holdings, this is the formula:

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

0.023 = HK$388m ÷ (HK$28b - HK$11b) (Based on the trailing twelve months to December 2020).

So, Digital China Holdings has an ROCE of 2.3%. Ultimately, that's a low return and it under-performs the IT industry average of 7.1%.

View our latest analysis for Digital China Holdings

Above you can see how the current ROCE for Digital China Holdings compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

The Trend Of ROCE

On the surface, the trend of ROCE at Digital China Holdings doesn't inspire confidence. Around five years ago the returns on capital were 3.9%, but since then they've fallen to 2.3%. 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. If these investments prove successful, this can bode very well for long term stock performance.

On a side note, Digital China Holdings has done well to pay down its current liabilities to 39% 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 Digital China Holdings' ROCE

In summary, despite lower returns in the short term, we're encouraged to see that Digital China Holdings is reinvesting for growth and has higher sales as a result. These trends are starting to be recognized by investors since the stock has delivered a 21% gain to shareholders who've held over the last five years. So this stock may still be an appealing investment opportunity, if other fundamentals prove to be sound.

One more thing, we've spotted 2 warning signs facing Digital China Holdings that you might find interesting.

While Digital China Holdings 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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