Today we'll evaluate Denbury Resources Inc. (NYSE:DNR) to determine whether it could have potential as an investment idea. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.
First of all, we'll work out how to 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.
Return On Capital Employed (ROCE): What is it?
ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. All else being equal, a better business will have a higher ROCE. Ultimately, it is a useful but imperfect metric. 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 Denbury Resources:
0.13 = US$558m ÷ (US$4.8b - US$325m) (Based on the trailing twelve months to September 2019.)
Therefore, Denbury Resources has an ROCE of 13%.
Is Denbury Resources's ROCE Good?
ROCE can be useful when making comparisons, such as between similar companies. Denbury Resources's ROCE appears to be substantially greater than the 8.5% average in the Oil and Gas industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Separate from Denbury Resources's performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
Denbury Resources has an ROCE of 13%, 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 Denbury Resources'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. ROCE is, after all, simply a snap shot of a single year. Remember that most companies like Denbury Resources are cyclical businesses. Since the future is so important for investors, you should check out our free report on analyst forecasts for Denbury Resources.
Do Denbury Resources's Current Liabilities Skew 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 counter this, investors can check if a company has high current liabilities relative to total assets.
Denbury Resources has total liabilities of US$325m and total assets of US$4.8b. Therefore its current liabilities are equivalent to approximately 6.8% of its total assets. With low current liabilities, Denbury Resources's decent ROCE looks that much more respectable.
The Bottom Line On Denbury Resources's ROCE
If it is able to keep this up, Denbury Resources could be attractive. There might be better investments than Denbury Resources out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
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If you spot an error that warrants correction, please contact the editor at email@example.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.