If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. So on that note, Chung Hung Steel (TPE:2014) looks quite promising in regards to its trends of return on capital.
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. Analysts use this formula to calculate it for Chung Hung Steel:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.042 = NT$915m ÷ (NT$27b - NT$5.2b) (Based on the trailing twelve months to December 2020).
Thus, Chung Hung Steel has an ROCE of 4.2%. On its own that's a low return on capital but it's in line with the industry's average returns of 3.6%.
Above you can see how the current ROCE for Chung Hung Steel compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Chung Hung Steel.
What The Trend Of ROCE Can Tell Us
Chung Hung Steel has broken into the black (profitability) and we're sure it's a sight for sore eyes. The company now earns 4.2% on its capital, because five years ago it was incurring losses. Interestingly, the capital employed by the business has remained relatively flat, so these higher returns are either from prior investments paying off or increased efficiencies. That being said, while an increase in efficiency is no doubt appealing, it'd be helpful to know if the company does have any investment plans going forward. After all, a company can only become a long term multi-bagger if it continually reinvests in itself at high rates of return.
In another part of our analysis, we noticed that the company's ratio of current liabilities to total assets decreased to 19%, which broadly means the business is relying less on its suppliers or short-term creditors to fund its operations. Therefore we can rest assured that the growth in ROCE is a result of the business' fundamental improvements, rather than a cooking class featuring this company's books.
What We Can Learn From Chung Hung Steel's ROCE
As discussed above, Chung Hung Steel appears to be getting more proficient at generating returns since capital employed has remained flat but earnings (before interest and tax) are up. And a remarkable 147% total return over the last five years tells us that investors are expecting more good things to come in the future. In light of that, we think it's worth looking further into this stock because if Chung Hung Steel can keep these trends up, it could have a bright future ahead.
If you'd like to know about the risks facing Chung Hung Steel, we've discovered 3 warning signs that you should be aware of.
While Chung Hung Steel isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.
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