Today we’ll look at Changhong Jiahua Holdings Limited (HKG:8016) and reflect on its potential as an investment. To be precise, we’ll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
First of all, we’ll work out how to calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. And finally, we’ll look at how its current liabilities are impacting its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. In general, businesses with a higher ROCE are usually better quality. In brief, it is a useful tool, but it is not without drawbacks. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since ‘No two businesses are exactly alike.’
How Do You Calculate Return On Capital Employed?
Analysts use this formula to calculate return on capital employed:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
Or for Changhong Jiahua Holdings:
0.24 = HK$340m ÷ (HK$4.6b – HK$2.9b) (Based on the trailing twelve months to September 2018.)
Therefore, Changhong Jiahua Holdings has an ROCE of 24%.
Is Changhong Jiahua Holdings’s ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that Changhong Jiahua Holdings’s ROCE is meaningfully better than the 11% average in the Electronic industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Setting aside the comparison to its industry for a moment, Changhong Jiahua Holdings’s ROCE in absolute terms currently looks quite high.
Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is, after all, simply a snap shot of a single year. How cyclical is Changhong Jiahua Holdings? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
Changhong Jiahua Holdings’s Current Liabilities And Their Impact On Its ROCE
Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Changhong Jiahua Holdings has total liabilities of HK$2.9b and total assets of HK$4.6b. Therefore its current liabilities are equivalent to approximately 64% of its total assets. While a high level of current liabilities boosts its ROCE, Changhong Jiahua Holdings’s returns are still very good.
What We Can Learn From Changhong Jiahua Holdings’s ROCE
So to us, the company is potentially worth investigating further. You might be able to find a better buy than Changhong Jiahua Holdings. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.