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Today we'll look at Yau Lee Holdings Limited (HKG:406) 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.
Firstly, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. And finally, we'll look at how its current liabilities are impacting its ROCE.
What is 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. 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'.
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 Yau Lee Holdings:
0.024 = HK$61m ÷ (HK$5.0b - HK$2.5b) (Based on the trailing twelve months to March 2019.)
So, Yau Lee Holdings has an ROCE of 2.4%.
Check out our latest analysis for Yau Lee Holdings
Does Yau Lee Holdings Have A Good ROCE?
One way to assess ROCE is to compare similar companies. We can see Yau Lee Holdings's ROCE is meaningfully below the Construction industry average of 13%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Independently of how Yau Lee Holdings compares to its industry, its ROCE in absolute terms is low; especially compared to the ~2.0% available in government bonds. There are potentially more appealing investments elsewhere.
Yau Lee Holdings delivered an ROCE of 2.4%, which is better than 3 years ago, as was making losses back then. That implies the business has been improving. The image below shows how Yau Lee Holdings's ROCE compares to its industry, and you can click it to see more detail on its past growth.
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. ROCE is, after all, simply a snap shot of a single year. How cyclical is Yau Lee Holdings? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.