If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for? Typically, we'll want to notice a trend of growing return on capital employed (ROCE) and alongside that, an expanding base of capital employed. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. Although, when we looked at ChangZhou KAIDI Electrical (SHSE:605288), it didn't seem to tick all of these boxes.
Understanding Return On Capital Employed (ROCE)
Just to clarify if you're unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. To calculate this metric for ChangZhou KAIDI Electrical, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.03 = CN¥65m ÷ (CN¥2.7b - CN¥459m) (Based on the trailing twelve months to September 2023).
So, ChangZhou KAIDI Electrical has an ROCE of 3.0%. In absolute terms, that's a low return and it also under-performs the Electrical industry average of 6.3%.
Historical performance is a great place to start when researching a stock so above you can see the gauge for ChangZhou KAIDI Electrical's ROCE against it's prior returns. If you're interested in investigating ChangZhou KAIDI Electrical's past further, check out this free graph covering ChangZhou KAIDI Electrical's past earnings, revenue and cash flow.
What The Trend Of ROCE Can Tell Us
On the surface, the trend of ROCE at ChangZhou KAIDI Electrical doesn't inspire confidence. Around five years ago the returns on capital were 50%, but since then they've fallen to 3.0%. Given the business is employing more capital while revenue has slipped, this is a bit concerning. 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.
On a related note, ChangZhou KAIDI Electrical has decreased its current liabilities to 17% of total assets. So we could link some of this to the decrease in ROCE. What's more, this can reduce some aspects of risk to the business because now the company's suppliers or short-term creditors are funding less of its operations. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.
The Key Takeaway
In summary, we're somewhat concerned by ChangZhou KAIDI Electrical's diminishing returns on increasing amounts of capital. Long term shareholders who've owned the stock over the last three years have experienced a 51% depreciation in their investment, so it appears the market might not like these trends either. That being the case, unless the underlying trends revert to a more positive trajectory, we'd consider looking elsewhere.
On a final note, we found 2 warning signs for ChangZhou KAIDI Electrical (1 doesn't sit too well with us) you should be aware of.
While ChangZhou KAIDI Electrical 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.