Ouhua Energy Holdings (SGX:AJ2) Could Be Struggling To Allocate Capital

To find a multi-bagger stock, what are the underlying trends we should look for in a business? Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base 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. So while Ouhua Energy Holdings (SGX:AJ2) has a high ROCE right now, lets see what we can decipher from how returns are changing.

Understanding Return On Capital Employed (ROCE)

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. Analysts use this formula to calculate it for Ouhua Energy Holdings:

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

0.27 = CN¥70m ÷ (CN¥740m - CN¥483m) (Based on the trailing twelve months to June 2022).

Thus, Ouhua Energy Holdings has an ROCE of 27%. On its own that's a fantastic return on capital, though it's the same as the Oil and Gas industry average of 27%.

Check out our latest analysis for Ouhua Energy Holdings

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're interested in investigating Ouhua Energy Holdings' past further, check out this free graph of past earnings, revenue and cash flow.

How Are Returns Trending?

On the surface, the trend of ROCE at Ouhua Energy Holdings doesn't inspire confidence. To be more specific, while the ROCE is still high, it's fallen from 43% where it was five years ago. However, given capital employed and revenue have both increased it appears that the business is currently pursuing growth, at the consequence of short term returns. If these investments prove successful, this can bode very well for long term stock performance.

On a side note, Ouhua Energy Holdings has done well to pay down its current liabilities to 65% of total assets. So we could link some of this to the decrease in ROCE. 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. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE. Keep in mind 65% is still pretty high, so those risks are still somewhat prevalent.

The Bottom Line

Even though returns on capital have fallen in the short term, we find it promising that revenue and capital employed have both increased for Ouhua Energy Holdings. Furthermore the stock has climbed 65% over the last five years, it would appear that investors are upbeat about the future. So while investors seem to be recognizing these promising trends, we would look further into this stock to make sure the other metrics justify the positive view.

If you want to know some of the risks facing Ouhua Energy Holdings we've found 4 warning signs (2 don't sit too well with us!) that you should be aware of before investing here.

If you'd like to see other companies earning high returns, check out our free list of companies earning high returns with solid balance sheets 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.