China Railway Signal & Communication (HKG:3969) Might Be Having Difficulty Using Its Capital Effectively

To find a multi-bagger stock, what are the underlying trends we should look for in a business? Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. In light of that, when we looked at China Railway Signal & Communication (HKG:3969) and its ROCE trend, we weren't exactly thrilled.

Understanding Return On Capital Employed (ROCE)

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. Analysts use this formula to calculate it for China Railway Signal & Communication:

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

0.095 = CN¥4.6b ÷ (CN¥104b - CN¥56b) (Based on the trailing twelve months to March 2021).

Thus, China Railway Signal & Communication has an ROCE of 9.5%. In absolute terms, that's a low return but it's around the Electronic industry average of 8.2%.

Check out our latest analysis for China Railway Signal & Communication

Above you can see how the current ROCE for China Railway Signal & Communication compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering China Railway Signal & Communication here for free.

What Does the ROCE Trend For China Railway Signal & Communication Tell Us?

In terms of China Railway Signal & Communication's historical ROCE movements, the trend isn't fantastic. To be more specific, ROCE has fallen from 13% over the last five years. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.

On a side note, China Railway Signal & Communication's current liabilities are still rather high at 54% of total assets. This effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. Ideally we'd like to see this reduce as that would mean fewer obligations bearing risks.

In Conclusion...

Bringing it all together, while we're somewhat encouraged by China Railway Signal & Communication's reinvestment in its own business, we're aware that returns are shrinking. And in the last five years, the stock has given away 36% so the market doesn't look too hopeful on these trends strengthening any time soon. In any case, the stock doesn't have these traits of a multi-bagger discussed above, so if that's what you're looking for, we think you'd have more luck elsewhere.

China Railway Signal & Communication does have some risks though, and we've spotted 1 warning sign for China Railway Signal & Communication that you might be interested in.

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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