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Today we’ll look at Imperial Oil Limited (TSE:IMO) 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.
Firstly, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. 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. All else being equal, a better business will have a higher ROCE. 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?
The formula for calculating the return on capital employed is:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)
Or for Imperial Oil:
0.075 = CA$2.8b ÷ (CA$42b – CA$5.0b) (Based on the trailing twelve months to March 2019.)
So, Imperial Oil has an ROCE of 7.5%.
Does Imperial Oil Have A Good ROCE?
One way to assess ROCE is to compare similar companies. In our analysis, Imperial Oil’s ROCE is meaningfully higher than the 5.5% average in the Oil and Gas industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Setting aside the industry comparison for now, Imperial Oil’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.
Our data shows that Imperial Oil currently has an ROCE of 7.5%, compared to its ROCE of 2.9% 3 years ago. This makes us think the business might be improving.
It is important to remember that ROCE shows past performance, and is not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. This is because ROCE only looks at one year, instead of considering returns across a whole cycle. Remember that most companies like Imperial Oil are cyclical businesses. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
How Imperial Oil’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 check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Imperial Oil has total assets of CA$42b and current liabilities of CA$5.0b. Therefore its current liabilities are equivalent to approximately 12% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.
Our Take On Imperial Oil’s ROCE
That said, Imperial Oil’s ROCE is mediocre, there may be more attractive investments around. 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 Imperial Oil 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 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.