Are K W Nelson Interior Design and Contracting Group Limited’s (HKG:8411) High Returns Really That Great?

Today we’ll evaluate K W Nelson Interior Design and Contracting Group Limited (HKG:8411) to determine whether it could have potential as an investment idea. To be precise, we’ll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

First, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. Finally, we’ll look at how its current liabilities affect its ROCE.

Return On Capital Employed (ROCE): What is it?

ROCE measures the ‘return’ (pre-tax profit) a company generates from capital employed 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 K W Nelson Interior Design and Contracting Group:

0.25 = HK$32m ÷ (HK$172m – HK$43m) (Based on the trailing twelve months to December 2019.)

Therefore, K W Nelson Interior Design and Contracting Group has an ROCE of 25%.

See our latest analysis for K W Nelson Interior Design and Contracting Group

Is K W Nelson Interior Design and Contracting Group’s ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. In our analysis, K W Nelson Interior Design and Contracting Group’s ROCE is meaningfully higher than the 11% average in the Consumer Services industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Putting aside its position relative to its industry for now, in absolute terms, K W Nelson Interior Design and Contracting Group’s ROCE is currently very good.

K W Nelson Interior Design and Contracting Group’s current ROCE of 25% is lower than 3 years ago, when the company reported a 36% ROCE. This makes us wonder if the business is facing new challenges. The image below shows how K W Nelson Interior Design and Contracting Group’s ROCE compares to its industry, and you can click it to see more detail on its past growth.

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Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately predict the future. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is only a point-in-time measure. If K W Nelson Interior Design and Contracting Group is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.

What Are Current Liabilities, And How Do They Affect K W Nelson Interior Design and Contracting Group’s ROCE?

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counteract this, we check if a company has high current liabilities, relative to its total assets.

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