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Don’t Buy Cue Energy Resources Limited (ASX:CUE) Until You Understand Its ROCE

Simply Wall St

Today we are going to look at Cue Energy Resources Limited (ASX:CUE) to see whether it might be an attractive investment prospect. 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. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. Generally speaking a higher ROCE is better. 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'.

How Do You Calculate Return On Capital Employed?

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 Cue Energy Resources:

0.13 = AU$7.5m ÷ (AU$64m - AU$5.1m) (Based on the trailing twelve months to December 2019.)

Therefore, Cue Energy Resources has an ROCE of 13%.

View our latest analysis for Cue Energy Resources

Is Cue Energy Resources's ROCE Good?

One way to assess ROCE is to compare similar companies. Using our data, Cue Energy Resources's ROCE appears to be around the 11% average of the Oil and Gas industry. Independently of how Cue Energy Resources compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.

Cue Energy Resources delivered an ROCE of 13%, which is better than 3 years ago, as was making losses back then. This makes us wonder if the company is improving. You can see in the image below how Cue Energy Resources's ROCE compares to its industry. Click to see more on past growth.

ASX:CUE Past Revenue and Net Income, February 25th 2020

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is, after all, simply a snap shot of a single year. Remember that most companies like Cue Energy Resources are cyclical businesses. How cyclical is Cue Energy Resources? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.

Do Cue Energy Resources's Current Liabilities Skew 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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Cue Energy Resources has current liabilities of AU$5.1m and total assets of AU$64m. Therefore its current liabilities are equivalent to approximately 8.0% of its total assets. Low current liabilities have only a minimal impact on Cue Energy Resources's ROCE, making its decent returns more credible.

The Bottom Line On Cue Energy Resources's ROCE

If it is able to keep this up, Cue Energy Resources could be attractive. There might be better investments than Cue Energy 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.

I will like Cue Energy Resources better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

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. Thank you for reading.