What underlying fundamental trends can indicate that a company might be in decline? A business that's potentially in decline often shows two trends, a return on capital employed (ROCE) that's declining, and a base of capital employed that's also declining. Basically the company is earning less on its investments and it is also reducing its total assets. So after we looked into NetDragon Websoft Holdings (HKG:777), the trends above didn't look too great.
Return On Capital Employed (ROCE): What Is It?
For those who don't know, ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. To calculate this metric for NetDragon Websoft Holdings, this is the formula:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.12 = CN¥785m ÷ (CN¥11b - CN¥4.1b) (Based on the trailing twelve months to June 2024).
Thus, NetDragon Websoft Holdings has an ROCE of 12%. In absolute terms, that's a pretty normal return, and it's somewhat close to the Entertainment industry average of 11%.
View our latest analysis for NetDragon Websoft Holdings
In the above chart we have measured NetDragon Websoft Holdings' prior ROCE against its prior performance, but the future is arguably more important. If you're interested, you can view the analysts predictions in our free analyst report for NetDragon Websoft Holdings .
What Does the ROCE Trend For NetDragon Websoft Holdings Tell Us?
We are a bit worried about the trend of returns on capital at NetDragon Websoft Holdings. Unfortunately the returns on capital have diminished from the 15% that they were earning five years ago. Meanwhile, capital employed in the business has stayed roughly the flat over the period. Companies that exhibit these attributes tend to not be shrinking, but they can be mature and facing pressure on their margins from competition. If these trends continue, we wouldn't expect NetDragon Websoft Holdings to turn into a multi-bagger.
While on the subject, we noticed that the ratio of current liabilities to total assets has risen to 38%, which has impacted the ROCE. If current liabilities hadn't increased as much as they did, the ROCE could actually be even lower. Keep an eye on this ratio, because the business could encounter some new risks if this metric gets too high.
The Bottom Line
All in all, the lower returns from the same amount of capital employed aren't exactly signs of a compounding machine. And long term shareholders have watched their investments stay flat over the last five years. With underlying trends that aren't great in these areas, we'd consider looking elsewhere.
One more thing to note, we've identified 2 warning signs with NetDragon Websoft Holdings and understanding them should be part of your investment process.
While NetDragon Websoft Holdings 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.