Ignoring the stock price of a company, what are the underlying trends that tell us a business is past the growth phase? Businesses in decline often have two underlying trends, firstly, a declining return on capital employed (ROCE) and a declining base of capital employed. This indicates the company is producing less profit from its investments and its total assets are decreasing. On that note, looking into Perfect World (SZSE:002624), we weren't too upbeat about how things were going.
Understanding Return On Capital Employed (ROCE)
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 Perfect World is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.073 = CN¥881m ÷ (CN¥16b - CN¥4.0b) (Based on the trailing twelve months to March 2023).
Thus, Perfect World has an ROCE of 7.3%. On its own, that's a low figure but it's around the 6.1% average generated by the Entertainment industry.
View our latest analysis for Perfect World
In the above chart we have measured Perfect World'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 Perfect World.
So How Is Perfect World's ROCE Trending?
There is reason to be cautious about Perfect World, given the returns are trending downwards. To be more specific, the ROCE was 15% five years ago, but since then it has dropped noticeably. On top of that, it's worth noting that the amount of capital employed within the business has remained relatively steady. Companies that exhibit these attributes tend to not be shrinking, but they can be mature and facing pressure on their margins from competition. If these trends continue, we wouldn't expect Perfect World to turn into a multi-bagger.
In Conclusion...
In the end, the trend of lower returns on the same amount of capital isn't typically an indication that we're looking at a growth stock. Investors haven't taken kindly to these developments, since the stock has declined 15% from where it was five years ago. That being the case, unless the underlying trends revert to a more positive trajectory, we'd consider looking elsewhere.
Since virtually every company faces some risks, it's worth knowing what they are, and we've spotted 3 warning signs for Perfect World (of which 1 shouldn't be ignored!) that you should know about.
While Perfect World 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.