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Are Imperial Oil Limited’s (TSE:IMO) High Returns Really That Great?

Simply Wall St

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Today we'll look at Imperial Oil Limited (TSE:IMO) and reflect on its potential as an investment. 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 of all, we'll work out how to 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.

Understanding Return On Capital Employed (ROCE)

ROCE measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Generally speaking a higher ROCE is better. 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.'

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 Imperial Oil:

0.082 = CA$3.1b ÷ (CA$41b - CA$4.0b) (Based on the trailing twelve months to December 2018.)

So, Imperial Oil has an ROCE of 8.2%.

See our latest analysis for Imperial Oil

Is Imperial Oil's ROCE Good?

ROCE is commonly used for comparing the performance of similar businesses. In our analysis, Imperial Oil's ROCE is meaningfully higher than the 5.7% average in the Oil and Gas industry. I think that's good to see, since it implies the company is better than other companies at making the most of its capital. Separate from how Imperial Oil 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.

Our data shows that Imperial Oil currently has an ROCE of 8.2%, compared to its ROCE of 4.8% 3 years ago. This makes us wonder if the company is improving.

TSX:IMO Past Revenue and Net Income, April 1st 2019

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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Remember that most companies like Imperial Oil are cyclical businesses. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Imperial Oil.

What Are Current Liabilities, And How Do They Affect Imperial Oil's ROCE?

Current liabilities are short term bills and invoices that need to be paid in 12 months or less. Due to the way the ROCE equation works, having large bills due in the near term can make it look as though a company has less capital employed, and thus a higher ROCE than usual. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Imperial Oil has total assets of CA$41b and current liabilities of CA$4.0b. Therefore its current liabilities are equivalent to approximately 9.5% of its total assets. Imperial Oil reports few current liabilities, which have a negligible impact on its unremarkable ROCE.

What We Can Learn From Imperial Oil's ROCE

Based on this information, Imperial Oil 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 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.