Today we'll look at Earthstone Energy, Inc. (NYSE:ESTE) 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.
Firstly, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Finally, we'll look at how its current liabilities affect 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. 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?
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 Earthstone Energy:
0.072 = US$67m ÷ (US$1.0b - US$79m) (Based on the trailing twelve months to March 2019.)
Therefore, Earthstone Energy has an ROCE of 7.2%.
Is Earthstone Energy's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. Using our data, Earthstone Energy's ROCE appears to be around the 7.6% average of the Oil and Gas industry. Separate from how Earthstone Energy stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. Investors may wish to consider higher-performing investments.
Earthstone Energy delivered an ROCE of 7.2%, which is better than 3 years ago, as was making losses back then. That implies the business has been improving. You can see in the image below how Earthstone Energy's ROCE compares to its industry. Click to see more on past growth.
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. ROCE is only a point-in-time measure. Remember that most companies like Earthstone Energy are cyclical businesses. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Earthstone Energy.
Do Earthstone Energy'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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Earthstone Energy has total assets of US$1.0b and current liabilities of US$79m. As a result, its current liabilities are equal to approximately 7.8% of its total assets. Earthstone Energy has a low level of current liabilities, which have a minimal impact on its uninspiring ROCE.
What We Can Learn From Earthstone Energy's ROCE
Based on this information, Earthstone Energy appears to be a mediocre business. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E 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).
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 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.