Today we are going to look at Encana Corporation (TSE:ECA) to see whether it might be an attractive investment prospect. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First, we'll go over how we calculate ROCE. Second, we'll look at its ROCE compared to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. 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 Encana:
0.10 = US$1.9b ÷ (US$22b - US$2.4b) (Based on the trailing twelve months to June 2019.)
So, Encana has an ROCE of 10.0%.
Is Encana's ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that Encana's ROCE is meaningfully better than the 5.8% 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. Independently of how Encana compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
Encana delivered an ROCE of 10.0%, which is better than 3 years ago, as was making losses back then. That suggests the business has returned to profitability. You can see in the image below how Encana's ROCE compares to its industry. Click to see more on past growth.
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. We note Encana could be considered a cyclical business. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Encana.
What Are Current Liabilities, And How Do They Affect Encana's 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.
Encana has total liabilities of US$2.4b and total assets of US$22b. Therefore its current liabilities are equivalent to approximately 11% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
What We Can Learn From Encana's ROCE
This is good to see, and with a sound ROCE, Encana could be worth a closer look. Encana shapes up well under this analysis, but it is far from the only business delivering excellent numbers . You might also want to check this free collection of companies delivering excellent earnings growth.
I will like Encana better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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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.