Finding a business that has the potential to grow substantially is not easy, but it is possible if we look at a few key financial metrics. Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base of capital employed. Ultimately, this demonstrates that it's a business that is reinvesting profits at increasing rates of return. However, after briefly looking over the numbers, we don't think Leader Harmonious Drive Systems (SHSE:688017) has the makings of a multi-bagger going forward, but let's have a look at why that may be.
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. The formula for this calculation on Leader Harmonious Drive Systems is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.017 = CN¥38m ÷ (CN¥2.8b - CN¥603m) (Based on the trailing twelve months to September 2023).
Thus, Leader Harmonious Drive Systems has an ROCE of 1.7%. Ultimately, that's a low return and it under-performs the Machinery industry average of 6.2%.
View our latest analysis for Leader Harmonious Drive Systems
Above you can see how the current ROCE for Leader Harmonious Drive Systems compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like, you can check out the forecasts from the analysts covering Leader Harmonious Drive Systems here for free.
What Does the ROCE Trend For Leader Harmonious Drive Systems Tell Us?
On the surface, the trend of ROCE at Leader Harmonious Drive Systems doesn't inspire confidence. Around five years ago the returns on capital were 11%, but since then they've fallen to 1.7%. And considering revenue has dropped while employing more capital, we'd be cautious. 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.
While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 22%, which has impacted the ROCE. Without this increase, it's likely that ROCE would be even lower than 1.7%. Keep an eye on this ratio, because the business could encounter some new risks if this metric gets too high.
The Key Takeaway
In summary, we're somewhat concerned by Leader Harmonious Drive Systems' diminishing returns on increasing amounts of capital. Yet despite these concerning fundamentals, the stock has performed strongly with a 92% return over the last three years, so investors appear very optimistic. 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've found 2 warning signs for Leader Harmonious Drive Systems that we think you should be aware of.
If you want to search for solid companies with great earnings, check out this free list of companies with good balance sheets and impressive returns on equity.
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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.