Why We’re Not Impressed By Fonterra Co-operative Group Limited’s (NZSE:FCG) 4.8% ROCE

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Today we’ll evaluate Fonterra Co-operative Group Limited (NZSE:FCG) to determine whether it could have potential as an investment idea. Specifically, we’ll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.

First up, we’ll look at what ROCE is and how we calculate it. Next, we’ll compare it to others in its industry. Then we’ll determine how its current liabilities are affecting its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. 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’.

So, How Do We Calculate ROCE?

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 Fonterra Co-operative Group:

0.048 = NZ$695m ÷ (NZ$20b – NZ$5.8b) (Based on the trailing twelve months to January 2019.)

Therefore, Fonterra Co-operative Group has an ROCE of 4.8%.

Check out our latest analysis for Fonterra Co-operative Group

Does Fonterra Co-operative Group Have A Good ROCE?

One way to assess ROCE is to compare similar companies. We can see Fonterra Co-operative Group’s ROCE is meaningfully below the Food industry average of 8.5%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Independently of how Fonterra Co-operative Group compares to its industry, its ROCE in absolute terms is low; especially compared to the ~2.4% available in government bonds. It is likely that there are more attractive prospects out there.

Fonterra Co-operative Group’s current ROCE of 4.8% is lower than 3 years ago, when the company reported a 8.2% ROCE. So investors might consider if it has had issues recently.

NZSE:FCG Past Revenue and Net Income, April 29th 2019
NZSE:FCG Past Revenue and Net Income, April 29th 2019

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is only a point-in-time measure. If Fonterra Co-operative Group is cyclical, it could make sense to check out this free graph of past earnings, revenue and cash flow.

Fonterra Co-operative Group’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. 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Fonterra Co-operative Group has total assets of NZ$20b and current liabilities of NZ$5.8b. As a result, its current liabilities are equal to approximately 29% of its total assets. This is a modest level of current liabilities, which will have a limited impact on the ROCE.

The Bottom Line On Fonterra Co-operative Group’s ROCE

While that is good to see, Fonterra Co-operative Group has a low ROCE and does not look attractive in this analysis. 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.