Huadian Power International (HKG:1071) Could Be Struggling To Allocate Capital

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. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. Having said that, from a first glance at Huadian Power International (HKG:1071) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.

Return On Capital Employed (ROCE): What is it?

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 Huadian Power International, this is the formula:

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

0.066 = CN¥12b ÷ (CN¥234b - CN¥55b) (Based on the trailing twelve months to March 2021).

So, Huadian Power International has an ROCE of 6.6%. Even though it's in line with the industry average of 7.2%, it's still a low return by itself.

Check out our latest analysis for Huadian Power International

In the above chart we have measured Huadian Power International's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Huadian Power International here for free.

What Can We Tell From Huadian Power International's ROCE Trend?

In terms of Huadian Power International's historical ROCE movements, the trend isn't fantastic. Over the last five years, returns on capital have decreased to 6.6% from 15% five years ago. Meanwhile, the business is utilizing more capital but this hasn't moved the needle much in terms of sales in the past 12 months, so this could reflect longer term investments. It may take some time before the company starts to see any change in earnings from these investments.

The Bottom Line

Bringing it all together, while we're somewhat encouraged by Huadian Power International's reinvestment in its own business, we're aware that returns are shrinking. And investors appear hesitant that the trends will pick up because the stock has fallen 19% in the last five years. Therefore based on the analysis done in this article, we don't think Huadian Power International has the makings of a multi-bagger.

One more thing to note, we've identified 2 warning signs with Huadian Power International and understanding them should be part of your investment process.

If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive returns on equity.

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