Today we'll look at China Ludao Technology Company Limited (HKG:2023) and reflect on its potential as an investment. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
First of all, we'll work out how to calculate ROCE. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. 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'.
So, How Do We Calculate ROCE?
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 Ludao Technology:
0.11 = CN¥47m ÷ (CN¥832m - CN¥394m) (Based on the trailing twelve months to June 2019.)
Therefore, China Ludao Technology has an ROCE of 11%.
Is China Ludao Technology's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. We can see China Ludao Technology's ROCE is meaningfully below the Household Products industry average of 14%. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Regardless of where China Ludao Technology sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
Our data shows that China Ludao Technology currently has an ROCE of 11%, compared to its ROCE of 1.6% 3 years ago. This makes us wonder if the company is improving. You can click on the image below to see (in greater detail) how China Ludao Technology's past growth compares to other companies.
When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. How cyclical is China Ludao Technology? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
Do China Ludao Technology's Current Liabilities Skew Its ROCE?
Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.
China Ludao Technology has total assets of CN¥832m and current liabilities of CN¥394m. Therefore its current liabilities are equivalent to approximately 47% of its total assets. With this level of current liabilities, China Ludao Technology's ROCE is boosted somewhat.
What We Can Learn From China Ludao Technology's ROCE
With a decent ROCE, the company could be interesting, but remember that the level of current liabilities make the ROCE look better. China Ludao Technology shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
I will like China Ludao Technology better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned.
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