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Are Evolution Petroleum Corporation’s (NYSEMKT:EPM) High Returns Really That Great?

Simply Wall St

Today we are going to look at Evolution Petroleum Corporation (NYSEMKT:EPM) 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, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. And finally, we'll look at how its current liabilities are impacting its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. Generally speaking a higher ROCE is better. In brief, it is a useful tool, but it is not without drawbacks. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.

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 Evolution Petroleum:

0.19 = US$18m ÷ (US$96m - US$2.8m) (Based on the trailing twelve months to June 2019.)

Therefore, Evolution Petroleum has an ROCE of 19%.

See our latest analysis for Evolution Petroleum

Is Evolution Petroleum's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. Using our data, we find that Evolution Petroleum's ROCE is meaningfully better than the 8.2% 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. Regardless of where Evolution Petroleum sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.

Our data shows that Evolution Petroleum currently has an ROCE of 19%, compared to its ROCE of 7.2% 3 years ago. This makes us wonder if the company is improving. You can click on the image below to see (in greater detail) how Evolution Petroleum's past growth compares to other companies.

AMEX:EPM Past Revenue and Net Income, October 29th 2019

It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Remember that most companies like Evolution Petroleum are cyclical businesses. Since the future is so important for investors, you should check out our free report on analyst forecasts for Evolution Petroleum.

Evolution Petroleum's Current Liabilities And Their Impact On Its ROCE

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To counteract this, we check if a company has high current liabilities, relative to its total assets.

Evolution Petroleum has total assets of US$96m and current liabilities of US$2.8m. Therefore its current liabilities are equivalent to approximately 2.9% of its total assets. With low current liabilities, Evolution Petroleum's decent ROCE looks that much more respectable.

What We Can Learn From Evolution Petroleum's ROCE

If Evolution Petroleum can continue reinvesting in its business, it could be an attractive prospect. There might be better investments than Evolution Petroleum 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.

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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.