Here's What To Make Of Kunming Dianchi Water Treatment's (HKG:3768) Returns On Capital

What are the early trends we should look for to identify a stock that could multiply in value over the long term? Amongst other things, we'll want to see two things; firstly, a growing return on capital employed (ROCE) and secondly, an expansion in the company's amount of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. However, after briefly looking over the numbers, we don't think Kunming Dianchi Water Treatment (HKG:3768) has the makings of a multi-bagger going forward, but let's have a look at why that may be.

Understanding Return On Capital Employed (ROCE)

Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. To calculate this metric for Kunming Dianchi Water Treatment, this is the formula:

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

0.069 = CN¥579m ÷ (CN¥10b - CN¥1.8b) (Based on the trailing twelve months to June 2020).

Thus, Kunming Dianchi Water Treatment has an ROCE of 6.9%. On its own that's a low return on capital but it's in line with the industry's average returns of 7.4%.

View our latest analysis for Kunming Dianchi Water Treatment

While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you'd like to look at how Kunming Dianchi Water Treatment has performed in the past in other metrics, you can view this free graph of past earnings, revenue and cash flow.

So How Is Kunming Dianchi Water Treatment's ROCE Trending?

On the surface, the trend of ROCE at Kunming Dianchi Water Treatment doesn't inspire confidence. Around five years ago the returns on capital were 10%, but since then they've fallen to 6.9%. Although, given both revenue and the amount of assets employed in the business have increased, it could suggest the company is investing in growth, and the extra capital has led to a short-term reduction in ROCE. If these investments prove successful, this can bode very well for long term stock performance.

On a side note, Kunming Dianchi Water Treatment has done well to pay down its current liabilities to 17% of total assets. That could partly explain why the ROCE has dropped. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.

What We Can Learn From Kunming Dianchi Water Treatment's ROCE

In summary, despite lower returns in the short term, we're encouraged to see that Kunming Dianchi Water Treatment 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 1.7% gain to shareholders who've held over the last three years. Therefore we'd recommend looking further into this stock to confirm if it has the makings of a good investment.

On a final note, we found 3 warning signs for Kunming Dianchi Water Treatment (2 make us uncomfortable) you should be aware of.

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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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. 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.
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