a2 Milk (NZSE:ATM) May Have Issues Allocating Its Capital

What are the early trends we should look for to identify a stock that could multiply in value over the long term? Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. In light of that, when we looked at a2 Milk (NZSE:ATM) and its ROCE trend, we weren't exactly thrilled.

What is Return On Capital Employed (ROCE)?

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. Analysts use this formula to calculate it for a2 Milk:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.12 = NZ$126m ÷ (NZ$1.4b - NZ$275m) (Based on the trailing twelve months to June 2021).

Therefore, a2 Milk has an ROCE of 12%. In absolute terms, that's a satisfactory return, but compared to the Food industry average of 8.4% it's much better.

View our latest analysis for a2 Milk

Above you can see how the current ROCE for a2 Milk compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.

So How Is a2 Milk's ROCE Trending?

When we looked at the ROCE trend at a2 Milk, we didn't gain much confidence. Around five years ago the returns on capital were 40%, but since then they've fallen to 12%. And considering revenue has dropped while employing more capital, we'd be cautious. This could mean that the business is losing its competitive advantage or market share, because while more money is being put into ventures, it's actually producing a lower return - "less bang for their buck" per se.

On a related note, a2 Milk has decreased its current liabilities to 20% of total assets. That could partly explain why the ROCE has dropped. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. Since the business is basically funding more of its operations with it's own money, you could argue this has made the business less efficient at generating ROCE.

The Key Takeaway

From the above analysis, we find it rather worrisome that returns on capital and sales for a2 Milk have fallen, meanwhile the business is employing more capital than it was five years ago. The market must be rosy on the stock's future because even though the underlying trends aren't too encouraging, the stock has soared 219%. Regardless, we don't feel too comfortable with the fundamentals so we'd be steering clear of this stock for now.

If you want to continue researching a2 Milk, you might be interested to know about the 1 warning sign that our analysis has discovered.

While a2 Milk may not currently earn the highest returns, we've compiled a list of companies that currently earn more than 25% return on equity. Check out this free list here.

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.

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