If we want to find a potential multi-bagger, often there are underlying trends that can provide clues. Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base of capital employed. If you see this, it typically means it's a company with a great business model and plenty of profitable reinvestment opportunities. Having said that, from a first glance at a2 Milk (NZSE:ATM) we aren't jumping out of our chairs at how returns are trending, but let's have a deeper look.
Understanding 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)
0.033 = NZ$40m ÷ (NZ$1.6b - NZ$387m) (Based on the trailing twelve months to December 2021).
Thus, 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%.
In the above chart we have measured a2 Milk's prior ROCE against its prior performance, but the future is arguably more important. 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?
In terms of a2 Milk's historical ROCE movements, the trend isn't fantastic. To be more specific, ROCE has fallen from 57% over the last five years. Given the business is employing more capital while revenue has slipped, this is a bit concerning. If this were to continue, you might be looking at a company that is trying to reinvest for growth but is actually losing market share since sales haven't increased.
The Bottom Line On a2 Milk's ROCE
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. In spite of that, the stock has delivered a 26% 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.
On a final note, we've found 3 warning signs for a2 Milk that we think you should be aware of.
While a2 Milk isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.
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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.