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Why We’re Not Keen On China Mengniu Dairy Company Limited’s (HKG:2319) 8.0% Return On Capital

Simply Wall St

Today we are going to look at China Mengniu Dairy Company Limited (HKG:2319) to see whether it might be an attractive investment prospect. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

First up, we'll look at what ROCE is and how we calculate it. Next, we'll compare it to others in its industry. 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 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?

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:

0.08 = CN¥3.3b ÷ (CN¥66b - CN¥25b) (Based on the trailing twelve months to December 2018.)

Therefore, China Mengniu Dairy has an ROCE of 8.0%.

View our latest analysis for China Mengniu Dairy

Does China Mengniu Dairy Have A Good ROCE?

One way to assess ROCE is to compare similar companies. Using our data, China Mengniu Dairy's ROCE appears to be significantly below the 11% average in the Food industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Separate from how China Mengniu Dairy stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. It is possible that there are more rewarding investments out there.

You can see in the image below how China Mengniu Dairy's ROCE compares to its industry. Click to see more on past growth.

SEHK:2319 Past Revenue and Net Income, August 6th 2019

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. Since the future is so important for investors, you should check out our free report on analyst forecasts for China Mengniu Dairy.

China Mengniu Dairy's Current Liabilities And Their Impact On 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.

China Mengniu Dairy has total assets of CN¥66b and current liabilities of CN¥25b. As a result, its current liabilities are equal to approximately 38% of its total assets. China Mengniu Dairy has a medium level of current liabilities, which would boost its ROCE somewhat.

Our Take On China Mengniu Dairy's ROCE

Unfortunately, its ROCE is still uninspiring, and there are potentially more attractive prospects 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.

If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).

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 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. Thank you for reading.