This analysis is intended to introduce important early concepts to people who are starting to invest and looking to gauge the potential return on investment in Synlait Milk Limited (NZSE:SML).
Buying Synlait Milk makes you a partial owner of the company. Your equity share is granted in return for the capital provided to the business to operate, and in order for an investment to be successful the business has to create earnings from the funds that make up this capital. Your return is tied to SML’s ability to do this because the amount earned is used to invest in opportunities to grow the business or payout dividends, which are the two sources of return on investment. To understand Synlait Milk’s capital returns we will look at a useful metric called return on capital employed. This will tell us if the company is growing your capital and placing you in good stead to sell your shares at a profit.
Synlait Milk’s Return On Capital Employed
As an investor you have many alternative companies to choose from, which means there is an opportunity cost in any investment you make in the form of a foregone investment in another company. The cost of missing out on another opportunity comes in the form of the potential long term gain you could’ve received, which is dependent on the gap between the return on capital you could’ve achieved and that of the company you invested in. Hence, capital returns are very important, and should be examined before you invest in conjunction with a certain benchmark that represents the minimum return you require to be compensated for the risk of missing out on other potentially lucrative investments. We’ll look at Synlait Milk’s returns by computing return on capital employed, which will tell us what the company can generate from the money spent in operations. Take a look at the formula box beneath:
ROCE Calculation for SML
Return on Capital Employed (ROCE) = Earnings Before Tax (EBT) ÷ (Capital Employed)
Capital Employed = (Total Assets – Current Liabilities)
∴ ROCE = NZ$96.30m ÷ (NZ$854.60m – NZ$292.34m) = 17.13%
SML’s 17.13% ROCE means that for every NZ$100 you invest, the company creates NZ$17.1. This shows Synlait Milk provides a favourable return to capital holders, which beats the 15% ROCE that is typically considered to be a strong benchmark. As a result, if SML is clever with their reinvestments or dividend payments, investors can grow their capital at an attractive rate over time.
Not so fast
The encouraging ROCE is good news for Synlait Milk investors if the company is able to maintain strong earnings and control their capital needs. But if this doesn’t occur, SML’s ROCE may deteriorate, in which case your money is better invested elsewhere. Because of this, it is important to look beyond the final value of SML’s ROCE and understand what is happening to the individual components. Looking three years in the past, it is evident that SML’s ROCE has risen from 8.55%, indicating the company’s capital returns have stengthened. Similarly, the movement in the earnings variable shows a jump from NZ$25.59m to NZ$96.30m whilst the amount of capital employed also grew but by a proportionally lesser volume, which suggests the larger ROCE is due to a growth in earnings relative to capital requirements.
SML’s investors have enjoyed an upward trend in ROCE and it is above a benchmark that makes the company a potentially attractive stock that can achieve a solid return on investment. This is an ideal situation to be in, but return on capital employed is a static metric that should be looked at in conjunction with other fundamental indicators like future prospects and valuation. It’s important to account for these factors because you cannot be sure if this trend will continue or if you are getting a good deal for the future returns you are paying for. If you’re interested in diving deeper, take a look at what I’ve linked below for further information on these fundamentals and other potential investment opportunities.
- Future Outlook: What are well-informed industry analysts predicting for SML’s future growth? Take a look at our free research report of analyst consensus for SML’s outlook.
- Valuation: What is SML worth today? Is the stock undervalued, even if its ROCE is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether SML is currently mispriced by the market.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.