Today we’ll look at Oil Search Limited (ASX:OSH) 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.
Firstly, 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.
Return On Capital Employed (ROCE): What is it?
ROCE measures the ‘return’ (pre-tax profit) a company generates from capital employed in its business. Generally speaking a higher ROCE is better. Ultimately, it is a useful but imperfect metric. 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 Oil Search:
0.062 = US$648m ÷ (US$12b – US$1.1b) (Based on the trailing twelve months to December 2019.)
So, Oil Search has an ROCE of 6.2%.
Does Oil Search Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. It appears that Oil Search’s ROCE is fairly close to the Oil and Gas industry average of 6.6%. Setting aside the industry comparison for now, Oil Search’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Readers may find more attractive investment prospects elsewhere.
In our analysis, Oil Search’s ROCE appears to be 6.2%, compared to 3 years ago, when its ROCE was 4.3%. This makes us think the business might be improving. The image below shows how Oil Search’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. We note Oil Search could be considered a cyclical business. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
Do Oil Search’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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Oil Search has current liabilities of US$1.1b and total assets of US$12b. As a result, its current liabilities are equal to approximately 9.7% of its total assets. Oil Search has a low level of current liabilities, which have a minimal impact on its uninspiring ROCE.
What We Can Learn From Oil Search’s ROCE
Based on this information, Oil Search appears to be a mediocre business. Of course, you might also be able to find a better stock than Oil Search. So you may wish to see this free collection of other companies that have grown earnings strongly.
Oil Search is not the only stock insiders are buying. So take a peek at this free list of growing companies with insider buying.
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.
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