If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base 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. Having said that, from a first glance at Shandong Hualu-Hengsheng Chemical (SHSE:600426) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.
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. To calculate this metric for Shandong Hualu-Hengsheng Chemical, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.12 = CN¥4.5b ÷ (CN¥41b - CN¥4.5b) (Based on the trailing twelve months to September 2023).
So, Shandong Hualu-Hengsheng Chemical has an ROCE of 12%. On its own, that's a standard return, however it's much better than the 5.5% generated by the Chemicals industry.
Check out our latest analysis for Shandong Hualu-Hengsheng Chemical
In the above chart we have measured Shandong Hualu-Hengsheng Chemical's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Shandong Hualu-Hengsheng Chemical here for free.
What The Trend Of ROCE Can Tell Us
On the surface, the trend of ROCE at Shandong Hualu-Hengsheng Chemical doesn't inspire confidence. Around five years ago the returns on capital were 25%, but since then they've fallen to 12%. And considering revenue has dropped while employing more capital, we'd be cautious. This could mean that the business is losing its competitive advantage or market share, because while more money is being put into ventures, it's actually producing a lower return - "less bang for their buck" per se.
On a side note, Shandong Hualu-Hengsheng Chemical has done well to pay down its current liabilities to 11% of total assets. So we could link some of this to the decrease in ROCE. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.
Our Take On Shandong Hualu-Hengsheng Chemical's ROCE
In summary, we're somewhat concerned by Shandong Hualu-Hengsheng Chemical's diminishing returns on increasing amounts of capital. Since the stock has skyrocketed 244% over the last five years, it looks like investors have high expectations of the stock. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.
On a final note, we found 3 warning signs for Shandong Hualu-Hengsheng Chemical (1 shouldn't be ignored) you should be aware of.
While Shandong Hualu-Hengsheng Chemical isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.
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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.