Shareholders Should Look Hard At Digital China Holdings Limited’s (HKG:861) 3.4%Return On Capital

Today we'll evaluate Digital China Holdings Limited (HKG:861) to determine whether it could have potential as an investment idea. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First of all, we'll work out how to 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.

Understanding Return On Capital Employed (ROCE)

ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. All else being equal, a better business will have a higher ROCE. Overall, it is a valuable metric that has its flaws. 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'.

How Do You Calculate Return On Capital Employed?

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 Digital China Holdings:

0.034 = HK$501m ÷ (HK$26b - HK$11b) (Based on the trailing twelve months to December 2019.)

So, Digital China Holdings has an ROCE of 3.4%.

View our latest analysis for Digital China Holdings

Is Digital China Holdings's ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. We can see Digital China Holdings's ROCE is meaningfully below the IT industry average of 10.0%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Putting aside Digital China Holdings's performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. Readers may wish to look for more rewarding investments.

Our data shows that Digital China Holdings currently has an ROCE of 3.4%, compared to its ROCE of 1.4% 3 years ago. This makes us wonder if the company is improving. You can see in the image below how Digital China Holdings's ROCE compares to its industry. Click to see more on past growth.

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

How Digital China Holdings's Current Liabilities Impact Its ROCE

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counteract this, we check if a company has high current liabilities, relative to its total assets.

Digital China Holdings has current liabilities of HK$11b and total assets of HK$26b. As a result, its current liabilities are equal to approximately 43% of its total assets. In light of sufficient current liabilities to noticeably boost the ROCE, Digital China Holdings's ROCE is concerning.

The Bottom Line On Digital China Holdings's ROCE

There are likely better investments out there. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

I will like Digital China Holdings better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.