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What trends should we look for it we want to identify stocks that can multiply in value over the long term? One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing 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. In light of that, when we looked at China Machinery Engineering (HKG:1829) and its ROCE trend, we weren’t exactly thrilled.
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. The formula for this calculation on China Machinery Engineering is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
0.079 = CN¥1.6b ÷ (CN¥51b – CN¥31b) (Based on the trailing twelve months to December 2020).
Thus, China Machinery Engineering has an ROCE of 7.9%. In absolute terms, that’s a low return but it’s around the Construction industry average of 9.4%.
See our latest analysis for China Machinery Engineering
In the above chart we have measured China Machinery Engineering’s prior ROCE against its prior performance, but the future is arguably more important. If you’d like to see what analysts are forecasting going forward, you should check out our free report for China Machinery Engineering.
What Can We Tell From China Machinery Engineering’s ROCE Trend?
When we looked at the ROCE trend at China Machinery Engineering, we didn’t gain much confidence. Around five years ago the returns on capital were 12%, but since then they’ve fallen to 7.9%. And considering revenue has dropped while employing more capital, we’d be cautious. If this were to continue, you might be looking at a company that is trying to reinvest for growth but is actually losing market share since sales haven’t increased.
Another thing to note, China Machinery Engineering has a high ratio of current liabilities to total assets of 61%. This effectively means that suppliers (or short-term creditors) are funding a large portion of the business, so just be aware that this can introduce some elements of risk. While it’s not necessarily a bad thing, it can be beneficial if this ratio is lower.
The Bottom Line
From the above analysis, we find it rather worrisome that returns on capital and sales for China Machinery Engineering have fallen, meanwhile the business is employing more capital than it was five years ago. Investors haven’t taken kindly to these developments, since the stock has declined 11% from where it was five years ago. With underlying trends that aren’t great in these areas, we’d consider looking elsewhere.
On a final note, we’ve found 1 warning sign for China Machinery Engineering that we think you should be aware of.
While China Machinery Engineering may not currently earn the highest returns, we’ve compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.
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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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