Today we are going to look at Continental Resources, Inc. (NYSE:CLR) to see whether it might be an attractive investment prospect. Specifically, we’re going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.
First of all, we’ll work out how to calculate ROCE. Then we’ll compare its ROCE to similar companies. Then we’ll determine how its current liabilities are affecting its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the business. All else being equal, a better business will have a higher ROCE. Overall, it is a valuable metric that has its flaws. 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 Continental Resources:
0.10 = US$1.5b ÷ (US$16b – US$1.4b) (Based on the trailing twelve months to June 2019.)
Therefore, Continental Resources has an ROCE of 10%.
Does Continental Resources Have A Good ROCE?
One way to assess ROCE is to compare similar companies. Continental Resources’s ROCE appears to be substantially greater than the 8.4% average in the Oil and Gas industry. I think that’s good to see, since it implies the company is better than other companies at making the most of its capital. Separate from how Continental Resources stacks up against its industry, its ROCE in absolute terms is mediocre; relative to the returns on government bonds. It is possible that there are more rewarding investments out there.
Continental Resources delivered an ROCE of 10%, which is better than 3 years ago, as was making losses back then. This makes us wonder if the company is improving.
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. We note Continental Resources could be considered a cyclical business. Since the future is so important for investors, you should check out our free report on analyst forecasts for Continental Resources.
Do Continental Resources’s Current Liabilities Skew 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 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.
Continental Resources has total liabilities of US$1.4b and total assets of US$16b. As a result, its current liabilities are equal to approximately 8.6% of its total assets. With low levels of current liabilities, at least Continental Resources’s mediocre ROCE is not unduly boosted.
What We Can Learn From Continental Resources’s ROCE
Continental Resources looks like an ok business, but on this analysis it is not at the top of our buy list. You might be able to find a better investment than Continental Resources. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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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.