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Today we'll look at Chesapeake Energy Corporation (NYSE:CHK) and reflect on its potential as an investment. 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. Second, we'll look at its ROCE compared to similar companies. 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. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. 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?
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 Chesapeake Energy:
0.099 = US$1.4b ÷ (US$17b - US$2.9b) (Based on the trailing twelve months to March 2019.)
Therefore, Chesapeake Energy has an ROCE of 9.9%.
Does Chesapeake Energy Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. In our analysis, Chesapeake Energy's ROCE is meaningfully higher than the 7.4% average in the Oil and Gas 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. Aside from the industry comparison, Chesapeake Energy's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.
Chesapeake Energy has an ROCE of 9.9%, but it didn't have an ROCE 3 years ago, since it was unprofitable. That implies the business has been improving. The image below shows how Chesapeake Energy's ROCE compares to its industry, and you can click it to see more detail on its past growth.
When considering ROCE, bear in mind that it reflects the past and does not necessarily 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. We note Chesapeake Energy could be considered a cyclical business. Since the future is so important for investors, you should check out our free report on analyst forecasts for Chesapeake Energy.
How Chesapeake Energy's Current Liabilities Impact 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 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Chesapeake Energy has total liabilities of US$2.9b and total assets of US$17b. As a result, its current liabilities are equal to approximately 18% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.
The Bottom Line On Chesapeake Energy's ROCE
With that in mind, we're not overly impressed with Chesapeake Energy's ROCE, so it may not be the most appealing prospect. Of course, you might also be able to find a better stock than Chesapeake Energy. 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).
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 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. Thank you for reading.