Today we’ll evaluate RAK Petroleum plc (OB:RAKP) to determine whether it could have potential as an investment idea. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
Firstly, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. 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. All else being equal, a better business will have a higher ROCE. 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 RAK Petroleum:
0.13 = US$426m ÷ (US$3.7b – US$317m) (Based on the trailing twelve months to June 2019.)
So, RAK Petroleum has an ROCE of 13%.
Is RAK Petroleum’s ROCE Good?
One way to assess ROCE is to compare similar companies. Using our data, we find that RAK Petroleum’s ROCE is meaningfully better than the 8.2% average in the Oil and Gas industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Separate from RAK Petroleum’s performance relative to its industry, its ROCE in absolute terms looks satisfactory, and it may be worth researching in more depth.
RAK Petroleum has an ROCE of 13%, but it didn’t have an ROCE 3 years ago, since it was unprofitable. This makes us wonder if the company is improving. The image below shows how RAK Petroleum’s ROCE compares to its industry, and you can click it to see more detail on its past growth.
It is important to remember that ROCE shows past performance, and is 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. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Remember that most companies like RAK Petroleum are cyclical businesses. How cyclical is RAK Petroleum? You can see for yourself by looking at this free graph of past earnings, revenue and cash flow.
RAK Petroleum’s Current Liabilities And Their Impact On Its 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 counter this, investors can check if a company has high current liabilities relative to total assets.
RAK Petroleum has total liabilities of US$317m and total assets of US$3.7b. As a result, its current liabilities are equal to approximately 8.6% of its total assets. In addition to low current liabilities (making a negligible impact on ROCE), RAK Petroleum earns a sound return on capital employed.
What We Can Learn From RAK Petroleum’s ROCE
This is good to see, and while better prospects may exist, RAK Petroleum seems worth researching further. There might be better investments than RAK Petroleum out there, but you will have to work hard to find them . These promising businesses with rapidly growing earnings might be right up your alley.
I will like RAK 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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