Today we'll evaluate Laredo Petroleum, Inc. (NYSE:LPI) to determine whether it could have potential as an investment idea. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
Firstly, 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.
What is Return On Capital Employed (ROCE)?
ROCE measures the amount of pre-tax profits a company can generate from the capital employed 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'.
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 Laredo Petroleum:
0.16 = US$398m ÷ (US$2.6b - US$171m) (Based on the trailing twelve months to June 2019.)
Therefore, Laredo Petroleum has an ROCE of 16%.
Is Laredo Petroleum's ROCE Good?
When making comparisons between similar businesses, investors may find ROCE useful. Using our data, we find that Laredo Petroleum's ROCE is meaningfully better than the 8.3% average in the Oil and Gas industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Independently of how Laredo Petroleum compares to its industry, its ROCE in absolute terms appears decent, and the company may be worthy of closer investigation.
In our analysis, Laredo Petroleum's ROCE appears to be 16%, compared to 3 years ago, when its ROCE was 13%. This makes us think about whether the company has been reinvesting shrewdly. The image below shows how Laredo Petroleum's ROCE compares to its industry, and you can click it to see more detail on its past growth.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is, after all, simply a snap shot of a single year. Given the industry it operates in, Laredo Petroleum could be considered cyclical. Since the future is so important for investors, you should check out our free report on analyst forecasts for Laredo Petroleum.
Laredo Petroleum's Current Liabilities And Their Impact On 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. 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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Laredo Petroleum has total liabilities of US$171m and total assets of US$2.6b. As a result, its current liabilities are equal to approximately 6.5% of its total assets. With low current liabilities, Laredo Petroleum's decent ROCE looks that much more respectable.
Our Take On Laredo Petroleum's ROCE
If Laredo Petroleum can continue reinvesting in its business, it could be an attractive prospect. Laredo Petroleum looks strong on this analysis, but there are plenty of other companies that could be a good opportunity . Here is a free list of companies growing earnings rapidly.
I will like Laredo Petroleum better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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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.