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Don’t Buy Extraction Oil & Gas, Inc. (NASDAQ:XOG) Until You Understand Its ROCE

Today we’ll evaluate Extraction Oil & Gas, Inc. (NASDAQ:XOG) to determine whether it could have potential as an investment idea. 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. Finally, we’ll look at how its current liabilities affect its ROCE.

Return On Capital Employed (ROCE): What is it?

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. In general, businesses with a higher ROCE are usually better quality. 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?

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 Extraction Oil & Gas:

0.06 = US$225m ÷ (US$4.2b – US$402m) (Based on the trailing twelve months to December 2018.)

So, Extraction Oil & Gas has an ROCE of 6.0%.

Check out our latest analysis for Extraction Oil & Gas

Is Extraction Oil & Gas’s ROCE Good?

When making comparisons between similar businesses, investors may find ROCE useful. It appears that Extraction Oil & Gas’s ROCE is fairly close to the Oil and Gas industry average of 7.4%. Setting aside the industry comparison for now, Extraction Oil & Gas’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Readers may find more attractive investment prospects elsewhere.

As we can see, Extraction Oil & Gas currently has an ROCE of 6.0% compared to its ROCE 3 years ago, which was 1.2%. This makes us think about whether the company has been reinvesting shrewdly.

NasdaqGS:XOG Past Revenue and Net Income, February 26th 2019
NasdaqGS:XOG Past Revenue and Net Income, February 26th 2019

It is important to remember that ROCE shows past performance, and is not necessarily predictive. 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. Remember that most companies like Extraction Oil & Gas are cyclical businesses. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Extraction Oil & Gas.

What Are Current Liabilities, And How Do They Affect Extraction Oil & Gas’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. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Extraction Oil & Gas has total liabilities of US$402m and total assets of US$4.2b. Therefore its current liabilities are equivalent to approximately 9.7% of its total assets. Extraction Oil & Gas reports few current liabilities, which have a negligible impact on its unremarkable ROCE.

Our Take On Extraction Oil & Gas’s ROCE

Extraction Oil & Gas looks like an ok business, but on this analysis it is not at the top of our buy list. Of course you might be able to find a better stock than Extraction Oil & Gas. 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 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. Thank you for reading.

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