What are the early trends we should look for to identify a stock that could multiply in value over the long term? Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. Although, when we looked at Mengtian Home Group (SHSE:603216), it didn't seem to tick all of these boxes.
Understanding Return On Capital Employed (ROCE)
If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. The formula for this calculation on Mengtian Home Group is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.046 = CN¥80m ÷ (CN¥2.3b - CN¥570m) (Based on the trailing twelve months to September 2023).
Thus, Mengtian Home Group has an ROCE of 4.6%. In absolute terms, that's a low return and it also under-performs the Building industry average of 6.4%.
While the past is not representative of the future, it can be helpful to know how a company has performed historically, which is why we have this chart above. If you want to delve into the historical earnings, revenue and cash flow of Mengtian Home Group, check out these free graphs here.
The Trend Of ROCE
When we looked at the ROCE trend at Mengtian Home Group, we didn't gain much confidence. Over the last five years, returns on capital have decreased to 4.6% from 37% five years ago. 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.
On a related note, Mengtian Home Group has decreased its current liabilities to 24% of total assets. Since the ratio used to be 77%, that's a significant reduction and it no doubt explains the drop in ROCE. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. 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 Bottom Line On Mengtian Home Group's ROCE
From the above analysis, we find it rather worrisome that returns on capital and sales for Mengtian Home Group have fallen, meanwhile the business is employing more capital than it was five years ago. It should come as no surprise then that the stock has fallen 27% over the last year, so it looks like investors are recognizing these changes. Unless there is a shift to a more positive trajectory in these metrics, we would look elsewhere.
If you want to continue researching Mengtian Home Group, you might be interested to know about the 1 warning sign that our analysis has discovered.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high 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.
