Today we’ll evaluate Evolution Petroleum Corporation (NYSEMKT:EPM) to determine whether it could have potential as an investment idea. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
Firstly, we’ll go over how we 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. In general, businesses with a higher ROCE are usually better quality. In brief, it is a useful tool, but it is not without drawbacks. 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 Evolution Petroleum:
0.21 = US$16m ÷ (US$96m – US$3.2m) (Based on the trailing twelve months to December 2018.)
Therefore, Evolution Petroleum has an ROCE of 21%.
Does Evolution Petroleum Have A Good ROCE?
ROCE is commonly used for comparing the performance of similar businesses. Evolution Petroleum’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. Setting aside the comparison to its industry for a moment, Evolution Petroleum’s ROCE in absolute terms currently looks quite high.
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 only a point-in-time measure. Remember that most companies like Evolution Petroleum are cyclical businesses. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Evolution Petroleum’s Current Liabilities And Their Impact On 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 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$3.2m. Therefore its current liabilities are equivalent to approximately 3.3% of its total assets. Evolution Petroleum has low current liabilities, which have a negligible impact on its relatively good ROCE.
What We Can Learn From Evolution Petroleum’s ROCE
This should mark the company as worthy of further investigation. But note: Evolution Petroleum may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
I will like Evolution Petroleum 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.