Today we'll evaluate The a2 Milk Company Limited (NZSE:ATM) 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. Then we'll determine how its current liabilities are affecting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Generally speaking a higher ROCE is better. 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'.
How Do You Calculate Return On Capital Employed?
Analysts use this formula to calculate return on capital employed:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
Or for a2 Milk:
0.52 = NZ$413m ÷ (NZ$993m - NZ$205m) (Based on the trailing twelve months to June 2019.)
Therefore, a2 Milk has an ROCE of 52%.
Does a2 Milk Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. In our analysis, a2 Milk's ROCE is meaningfully higher than the 7.9% average in the Food industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Putting aside its position relative to its industry for now, in absolute terms, a2 Milk's ROCE is currently very good.
Our data shows that a2 Milk currently has an ROCE of 52%, compared to its ROCE of 40% 3 years ago. This makes us wonder if the company is improving. You can see in the image below how a2 Milk'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. Since the future is so important for investors, you should check out our free report on analyst forecasts for a2 Milk.
How a2 Milk'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. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
a2 Milk has total assets of NZ$993m and current liabilities of NZ$205m. As a result, its current liabilities are equal to approximately 21% of its total assets. This is quite a low level of current liabilities which would not greatly boost the already high ROCE.
What We Can Learn From a2 Milk's ROCE
Low current liabilities and high ROCE is a good combination, making a2 Milk look quite interesting. There might be better investments than a2 Milk out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
I will like a2 Milk better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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.
If you spot an error that warrants correction, please contact the editor at email@example.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. Thank you for reading.