Today we'll look at Oil Search Limited (ASX:OSH) and reflect on its potential as an investment. 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. Next, we'll compare it to others in its industry. Finally, we'll look at how its current liabilities affect its ROCE.
Understanding 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. In general, businesses with a higher ROCE are usually better quality. Overall, it is a valuable metric that has its flaws. 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 Oil Search:
0.081 = US$830m ÷ (US$11b - US$1.2b) (Based on the trailing twelve months to June 2019.)
So, Oil Search has an ROCE of 8.1%.
Is Oil Search's ROCE Good?
One way to assess ROCE is to compare similar companies. We can see Oil Search's ROCE is meaningfully below the Oil and Gas industry average of 13%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Aside from the industry comparison, Oil Search's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.
We can see that, Oil Search currently has an ROCE of 8.1% compared to its ROCE 3 years ago, which was 0.2%. This makes us think the business might be improving. You can click on the image below to see (in greater detail) how Oil Search's past growth compares to other companies.
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 Oil Search are cyclical businesses. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
How Oil Search's Current Liabilities Impact 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.
Oil Search has total assets of US$11b and current liabilities of US$1.2b. As a result, its current liabilities are equal to approximately 10% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.
The Bottom Line On Oil Search's ROCE
With that in mind, we're not overly impressed with Oil Search's ROCE, so it may not be the most appealing prospect. Of course, you might also be able to find a better stock than Oil Search. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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