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What Can We Make Of Evolution Petroleum Corporation’s (NYSEMKT:EPM) High Return On Capital?

Simply Wall St

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Today we are going to look at Evolution Petroleum Corporation (NYSEMKT:EPM) to see whether it might be an attractive investment prospect. In particular, we'll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.

First up, we'll look at what ROCE is and how we calculate it. Next, we'll compare it to others in its industry. Then we'll determine how its current liabilities are affecting its ROCE.

What is Return On Capital Employed (ROCE)?

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. All else being equal, a better business will have a higher ROCE. 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$20m ÷ (US$96m - US$3.2m) (Based on the trailing twelve months to December 2018.)

So, Evolution Petroleum has an ROCE of 21%.

View our latest analysis for Evolution Petroleum

Does Evolution Petroleum Have A Good ROCE?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that Evolution Petroleum's ROCE is meaningfully better than the 7.7% 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.

AMEX:EPM Past Revenue and Net Income, May 9th 2019

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. 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.

Do Evolution Petroleum'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 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 counter this, investors can check if a company has high current liabilities relative to total assets.

Evolution Petroleum has total liabilities of US$3.2m and total assets of US$96m. As a result, its current liabilities are equal to approximately 3.3% of its total assets. Modest current liabilities are not boosting Evolution Petroleum's very nice ROCE.

What We Can Learn From Evolution Petroleum's ROCE

This is an attractive combination and suggests the company could have potential. Evolution Petroleum 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.

If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.

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.