Today we are going to look at Galp Energia, SGPS, S.A. (ELI:GALP) 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 of all, we’ll work out how to calculate ROCE. Then we’ll compare its ROCE to similar companies. Last but not least, we’ll look at what impact its current liabilities have on its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. Generally speaking a higher ROCE is better. Ultimately, it is a useful but imperfect metric. 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’.
So, How Do We Calculate ROCE?
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 Galp Energia SGPS:
0.16 = €1.6b ÷ (€13b – €2.6b) (Based on the trailing twelve months to December 2018.)
Therefore, Galp Energia SGPS has an ROCE of 16%.
Does Galp Energia SGPS Have A Good ROCE?
ROCE can be useful when making comparisons, such as between similar companies. Galp Energia SGPS’s ROCE appears to be substantially greater than the 8.9% 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. Regardless of where Galp Energia SGPS sits next to its industry, its ROCE in absolute terms appears satisfactory, and this company could be worth a closer look.
In our analysis, Galp Energia SGPS’s ROCE appears to be 16%, compared to 3 years ago, when its ROCE was 5.5%. This makes us think the business might be improving.
Remember that this metric is backwards looking – it shows what has happened in the past, and does not accurately predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is, after all, simply a snap shot of a single year. Remember that most companies like Galp Energia SGPS are cyclical businesses. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Galp Energia SGPS.
Do Galp Energia SGPS’s Current Liabilities Skew Its ROCE?
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. 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.
Galp Energia SGPS has total assets of €13b and current liabilities of €2.6b. Therefore its current liabilities are equivalent to approximately 21% of its total assets. Current liabilities are minimal, limiting the impact on ROCE.
What We Can Learn From Galp Energia SGPS’s ROCE
This is good to see, and with a sound ROCE, Galp Energia SGPS could be worth a closer look. But note: Galp Energia SGPS 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).
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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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. Thank you for reading.