Returns On Capital Signal Tricky Times Ahead For Guangdong Investment (HKG:270)

If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? 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. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. However, after briefly looking over the numbers, we don't think Guangdong Investment (HKG:270) 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?

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Analysts use this formula to calculate it for Guangdong Investment:

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

0.064 = HK$6.2b ÷ (HK$134b - HK$36b) (Based on the trailing twelve months to March 2023).

Thus, Guangdong Investment has an ROCE of 6.4%. Even though it's in line with the industry average of 6.5%, it's still a low return by itself.

See our latest analysis for Guangdong Investment

In the above chart we have measured Guangdong Investment'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 Guangdong Investment here for free.

The Trend Of ROCE

On the surface, the trend of ROCE at Guangdong Investment doesn't inspire confidence. Around five years ago the returns on capital were 9.9%, but since then they've fallen to 6.4%. And considering revenue has dropped while employing more capital, we'd be cautious. If this were to continue, you might be looking at a company that is trying to reinvest for growth but is actually losing market share since sales haven't increased.

While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 27%, which has impacted the ROCE. Without this increase, it's likely that ROCE would be even lower than 6.4%. Keep an eye on this ratio, because the business could encounter some new risks if this metric gets too high.

In Conclusion...

In summary, we're somewhat concerned by Guangdong Investment's diminishing returns on increasing amounts of capital. Investors haven't taken kindly to these developments, since the stock has declined 34% from where it was five years ago. Unless there is a shift to a more positive trajectory in these metrics, we would look elsewhere.

If you'd like to know more about Guangdong Investment, we've spotted 3 warning signs, and 1 of them is concerning.

While Guangdong Investment 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.