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Why Dril-Quip, Inc.’s (NYSE:DRQ) Return On Capital Employed Might Be A Concern

Simply Wall St

Today we'll look at Dril-Quip, Inc. (NYSE:DRQ) 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, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. 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. 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 Dril-Quip:

0.0051 = US$5.7m ÷ (US$1.2b - US$97m) (Based on the trailing twelve months to December 2019.)

So, Dril-Quip has an ROCE of 0.5%.

View our latest analysis for Dril-Quip

Is Dril-Quip's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. In this analysis, Dril-Quip's ROCE appears meaningfully below the 5.9% average reported by the Energy Services industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Regardless of how Dril-Quip stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). It is likely that there are more attractive prospects out there.

Dril-Quip's current ROCE of 0.5% is lower than 3 years ago, when the company reported a 8.6% ROCE. Therefore we wonder if the company is facing new headwinds. You can see in the image below how Dril-Quip's ROCE compares to its industry. Click to see more on past growth.

NYSE:DRQ Past Revenue and Net Income, March 2nd 2020

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. ROCE is, after all, simply a snap shot of a single year. Remember that most companies like Dril-Quip 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 Dril-Quip's Current Liabilities Impact Its ROCE

Current liabilities include invoices, such as supplier payments, short-term debt, or a tax bill, that need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counteract this, we check if a company has high current liabilities, relative to its total assets.

Dril-Quip has current liabilities of US$97m and total assets of US$1.2b. Therefore its current liabilities are equivalent to approximately 8.0% of its total assets. With barely any current liabilities, there is minimal impact on Dril-Quip's admittedly low ROCE.

What We Can Learn From Dril-Quip's ROCE

Nonetheless, there may be better places to invest your capital. Of course, you might also be able to find a better stock than Dril-Quip. So you may wish to see this free collection of other companies that have grown earnings strongly.

For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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.

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. Thank you for reading.