When we're researching a company, it's sometimes hard to find the warning signs, but there are some financial metrics that can help spot trouble early. When we see a declining return on capital employed (ROCE) in conjunction with a declining base of capital employed, that's often how a mature business shows signs of aging. This indicates to us that the business is not only shrinking the size of its net assets, but its returns are falling as well. Having said that, after a brief look, First Hotel (TPE:2706) we aren't filled with optimism, but let's investigate further.
Return On Capital Employed (ROCE): What is it?
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. Analysts use this formula to calculate it for First Hotel:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.017 = NT$175m ÷ (NT$10b - NT$355m) (Based on the trailing twelve months to September 2020).
Thus, First Hotel has an ROCE of 1.7%. In absolute terms, that's a low return and it also under-performs the Hospitality industry average of 5.6%.
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 want to delve into the historical earnings, revenue and cash flow of First Hotel, check out these free graphs here.
How Are Returns Trending?
In terms of First Hotel's historical ROCE movements, the trend doesn't inspire confidence. To be more specific, the ROCE was 2.6% five years ago, but since then it has dropped noticeably. On top of that, it's worth noting that the amount of capital employed within the business has remained relatively steady. This combination can be indicative of a mature business that still has areas to deploy capital, but the returns received aren't as high due potentially to new competition or smaller margins. If these trends continue, we wouldn't expect First Hotel to turn into a multi-bagger.
What We Can Learn From First Hotel's ROCE
In the end, the trend of lower returns on the same amount of capital isn't typically an indication that we're looking at a growth stock. And long term shareholders have watched their investments stay flat over the last five years. That being the case, unless the underlying trends revert to a more positive trajectory, we'd consider looking elsewhere.
One more thing: We've identified 3 warning signs with First Hotel (at least 1 which is significant) , and understanding them would certainly be useful.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
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