To find a multi-bagger stock, what are the underlying trends we should look for in a business? 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. Although, when we looked at Shandong Hualu-Hengsheng Chemical (SHSE:600426), 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. 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).

Thus, Shandong Hualu-Hengsheng Chemical has an ROCE of 12%. On its own, that's a standard return, however it's much better than the 5.7% generated by the Chemicals industry.

Above you can see how the current ROCE for Shandong Hualu-Hengsheng Chemical compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like to see what analysts are forecasting going forward, you should check out our free analyst report for Shandong Hualu-Hengsheng Chemical .

What Does the ROCE Trend For Shandong Hualu-Hengsheng Chemical 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. 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.

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. Yet despite these poor fundamentals, the stock has gained a huge 166% over the last five 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.

One final note, you should learn about the 3 warning signs we've spotted with Shandong Hualu-Hengsheng Chemical (including 1 which is a bit unpleasant) .

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.