Don’t Buy China Mengniu Dairy Company Limited (HKG:2319) Until You Understand Its ROCE
Today we'll evaluate China Mengniu Dairy Company Limited (HKG:2319) to determine whether it could have potential as an investment idea. Specifically, we'll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.
First, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Last but not least, we'll look at what impact its current liabilities have on its ROCE.
What is 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. In general, businesses with a higher ROCE are usually better quality. 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 China Mengniu Dairy:
0.096 = CN¥3.7b ÷ (CN¥74b - CN¥35b) (Based on the trailing twelve months to June 2019.)
So, China Mengniu Dairy has an ROCE of 9.6%.
View our latest analysis for China Mengniu Dairy
Is China Mengniu Dairy's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. It appears that China Mengniu Dairy's ROCE is fairly close to the Food industry average of 10%. Independently of how China Mengniu Dairy compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
We can see that, China Mengniu Dairy currently has an ROCE of 9.6% compared to its ROCE 3 years ago, which was 6.7%. This makes us think the business might be improving. You can click on the image below to see (in greater detail) how China Mengniu Dairy's past growth compares to other companies.
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 deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is only a point-in-time measure. Since the future is so important for investors, you should check out our free report on analyst forecasts for China Mengniu Dairy.
How China Mengniu Dairy's Current Liabilities Impact Its ROCE
Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
China Mengniu Dairy has current liabilities of CN¥35b and total assets of CN¥74b. Therefore its current liabilities are equivalent to approximately 47% of its total assets. With this level of current liabilities, China Mengniu Dairy's ROCE is boosted somewhat.
Our Take On China Mengniu Dairy's ROCE
While its ROCE looks good, it's worth remembering that the current liabilities are making the business look better. China Mengniu Dairy shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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.
