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Why We’re Not Impressed By Diamondback Energy, Inc.’s (NASDAQ:FANG) 5.7% ROCE

Simply Wall St

Today we'll look at Diamondback Energy, Inc. (NASDAQ:FANG) and reflect on its potential as an investment. To be precise, we'll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.

First, we'll go over how we calculate ROCE. Next, we'll compare it to others in its industry. Then we'll determine how its current liabilities are affecting its ROCE.

Understanding 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. 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.'

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 Diamondback Energy:

0.057 = US$1.2b ÷ (US$23b - US$1.2b) (Based on the trailing twelve months to June 2019.)

So, Diamondback Energy has an ROCE of 5.7%.

See our latest analysis for Diamondback Energy

Does Diamondback Energy Have A Good ROCE?

When making comparisons between similar businesses, investors may find ROCE useful. We can see Diamondback Energy's ROCE is meaningfully below the Oil and Gas industry average of 7.9%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Regardless of how Diamondback Energy stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). Readers may wish to look for more rewarding investments.

In our analysis, Diamondback Energy's ROCE appears to be 5.7%, compared to 3 years ago, when its ROCE was 4.0%. This makes us wonder if the company is improving. The image below shows how Diamondback Energy's ROCE compares to its industry, and you can click it to see more detail on its past growth.

NasdaqGS:FANG Past Revenue and Net Income, August 12th 2019

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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 only a point-in-time measure. Given the industry it operates in, Diamondback Energy could be considered cyclical. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Diamondback Energy.

How Diamondback Energy's Current Liabilities Impact Its ROCE

Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. 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 counter this, investors can check if a company has high current liabilities relative to total assets.

Diamondback Energy has total assets of US$23b and current liabilities of US$1.2b. As a result, its current liabilities are equal to approximately 5.1% of its total assets. Diamondback Energy has very few current liabilities, which have a minimal effect on its already low ROCE.

Our Take On Diamondback Energy's ROCE

Nonetheless, there may be better places to invest your capital. 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.

I will like Diamondback Energy better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

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.