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

If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Firstly, we'd want to identify a growing return on capital employed (ROCE) and then alongside that, an ever-increasing base of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. 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 that aren't sure what ROCE is, it measures the amount of pre-tax profits a company can generate from the capital employed in its business. The formula for this calculation on a2 Milk is:

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

0.033 = NZ$40m ÷ (NZ$1.6b - NZ$387m) (Based on the trailing twelve months to December 2021).

So, a2 Milk has an ROCE of 3.3%. Ultimately, that's a low return and it under-performs the Food industry average of 7.0%.

Check out 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'd like, you can check out the forecasts from the analysts covering a2 Milk here for free.

What Does the ROCE Trend For a2 Milk Tell Us?

On the surface, the trend of ROCE at a2 Milk doesn't inspire confidence. Around five years ago the returns on capital were 57%, but since then they've fallen to 3.3%. 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.

Our Take On a2 Milk's ROCE

We're a bit apprehensive about a2 Milk because despite more capital being deployed in the business, returns on that capital and sales have both fallen. In spite of that, the stock has delivered a 6.6% return to shareholders who held over the last five years. Either way, we aren't huge fans of the current trends and so with that we think you might find better investments elsewhere.

One more thing to note, we've identified 3 warning signs with a2 Milk and understanding these should be part of your investment process.

For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.

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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.