Are NetEase, Inc.’s (NASDAQ:NTES) High Returns Really That Great?

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Today we are going to look at NetEase, Inc. (NASDAQ:NTES) to see whether it might be an attractive investment prospect. Specifically, we'll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.

First up, we'll look at what ROCE is and how we calculate it. Then we'll compare its ROCE to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the 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?

Analysts use this formula to calculate return on capital employed:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

Or for NetEase:

0.18 = CN¥10b ÷ (CN¥91b - CN¥36b) (Based on the trailing twelve months to March 2019.)

Therefore, NetEase has an ROCE of 18%.

View our latest analysis for NetEase

Is NetEase's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. In our analysis, NetEase's ROCE is meaningfully higher than the 9.8% average in the Entertainment industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Independently of how NetEase compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

NetEase's current ROCE of 18% is lower than its ROCE in the past, which was 28%, 3 years ago. This makes us wonder if the business is facing new challenges.

NasdaqGS:NTES Past Revenue and Net Income, June 12th 2019

It is important to remember that ROCE shows past performance, and is 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 NetEase'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 ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counteract this, we check if a company has high current liabilities, relative to its total assets.

NetEase has total assets of CN¥91b and current liabilities of CN¥36b. Therefore its current liabilities are equivalent to approximately 40% of its total assets. NetEase has a middling amount of current liabilities, increasing its ROCE somewhat.

What We Can Learn From NetEase's ROCE

With a decent ROCE, the company could be interesting, but remember that the level of current liabilities make the ROCE look better. There might be better investments than NetEase out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.

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We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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. Thank you for reading.