Today we are going to look at China Shengmu Organic Milk Limited (HKG:1432) to see whether it might be an attractive investment prospect. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First up, we'll look at what ROCE is and how we calculate it. Next, we'll compare it to others in its industry. And finally, we'll look at how its current liabilities are impacting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. All else being equal, a better business will have a higher ROCE. Overall, it is a valuable metric that has its flaws. 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?
Analysts use this formula to calculate return on capital employed:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
Or for China Shengmu Organic Milk:
0.20 = CN¥490m ÷ (CN¥6.6b - CN¥4.1b) (Based on the trailing twelve months to December 2019.)
So, China Shengmu Organic Milk has an ROCE of 20%.
Is China Shengmu Organic Milk's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. In our analysis, China Shengmu Organic Milk's ROCE is meaningfully higher than the 11% average in the Food industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Putting aside its position relative to its industry for now, in absolute terms, China Shengmu Organic Milk's ROCE is currently very good.
In our analysis, China Shengmu Organic Milk's ROCE appears to be 20%, compared to 3 years ago, when its ROCE was 15%. This makes us think about whether the company has been reinvesting shrewdly. You can click on the image below to see (in greater detail) how China Shengmu Organic Milk's past growth compares to other companies.
Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is only a point-in-time measure. You can check if China Shengmu Organic Milk has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.
China Shengmu Organic Milk's Current Liabilities And Their Impact On Its ROCE
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counteract this, we check if a company has high current liabilities, relative to its total assets.
China Shengmu Organic Milk has current liabilities of CN¥4.1b and total assets of CN¥6.6b. As a result, its current liabilities are equal to approximately 62% of its total assets. While a high level of current liabilities boosts its ROCE, China Shengmu Organic Milk's returns are still very good.
What We Can Learn From China Shengmu Organic Milk's ROCE
In my book, this business could be worthy of further research. China Shengmu Organic Milk looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.
I will like China Shengmu Organic Milk better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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