Today we’ll evaluate China Machinery Engineering Corporation (HKG:1829) to determine whether it could have potential as an investment idea. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. Then we’ll determine how its current liabilities are affecting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. All else being equal, a better business will have a higher ROCE. In brief, it is a useful tool, but it is not without drawbacks. Renowned investment researcher Michael Mauboussin has suggested that a high ROCE can indicate that ‘one dollar invested in the company generates value of more than one dollar’.
How Do You Calculate Return On Capital Employed?
The formula for calculating the return on capital employed is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
Or for China Machinery Engineering:
0.16 = CN¥2.5b ÷ (CN¥58b – CN¥42b) (Based on the trailing twelve months to June 2018.)
So, China Machinery Engineering has an ROCE of 16%.
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Is China Machinery Engineering’s ROCE Good?
One way to assess ROCE is to compare similar companies. We can see China Machinery Engineering’s ROCE is around the 14% average reported by the Construction industry. Regardless of where China Machinery Engineering sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
SEHK:1829 Last Perf January 21st 19
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Do China Machinery Engineering’s Current Liabilities Skew Its ROCE?
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
China Machinery Engineering has total assets of CN¥58b and current liabilities of CN¥42b. As a result, its current liabilities are equal to approximately 72% of its total assets. China Machinery Engineering’s current liabilities are fairly high, which increases its ROCE significantly.
Our Take On China Machinery Engineering’s ROCE
While its ROCE looks decent, it wouldn’t look so good if it reduced current liabilities. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at [email protected].