Today we'll evaluate Centennial Resource Development, Inc. (NASDAQ:CDEV) to determine whether it could have potential as an investment idea. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
Firstly, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Last but not least, we'll look at what impact its current liabilities have on 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. Generally speaking a higher ROCE is better. In brief, it is a useful tool, but it is not without drawbacks. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.
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 Centennial Resource Development:
0.037 = US$160m ÷ (US$4.6b - US$287m) (Based on the trailing twelve months to September 2019.)
Therefore, Centennial Resource Development has an ROCE of 3.7%.
Does Centennial Resource Development Have A Good ROCE?
One way to assess ROCE is to compare similar companies. Using our data, Centennial Resource Development's ROCE appears to be significantly below the 8.9% average in the Oil and Gas industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Putting aside Centennial Resource Development's performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. It is likely that there are more attractive prospects out there.
Centennial Resource Development has an ROCE of 3.7%, but it didn't have an ROCE 3 years ago, since it was unprofitable. This makes us wonder if the company is improving. The image below shows how Centennial Resource Development's ROCE compares to its industry, and you can click it to see more detail on its past growth.
Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is only a point-in-time measure. Remember that most companies like Centennial Resource Development are cyclical businesses. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
What Are Current Liabilities, And How Do They Affect Centennial Resource Development's 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Centennial Resource Development has total assets of US$4.6b and current liabilities of US$287m. As a result, its current liabilities are equal to approximately 6.2% of its total assets. Centennial Resource Development has very few current liabilities, which have a minimal effect on its already low ROCE.
The Bottom Line On Centennial Resource Development's ROCE
Nonetheless, there may be better places to invest your capital. Of course, you might also be able to find a better stock than Centennial Resource Development. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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