To find a multi-bagger stock, what are the underlying trends we should look for in a business? Firstly, we'll want to see a proven return on capital employed (ROCE) that is increasing, and secondly, an expanding base of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. With that in mind, we've noticed some promising trends at Tullow Oil (LON:TLW) so let's look a bit deeper.
Return On Capital Employed (ROCE): What is it?
If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Analysts use this formula to calculate it for Tullow Oil:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.13 = US$277m ÷ (US$6.6b - US$4.4b) (Based on the trailing twelve months to December 2020).
Therefore, Tullow Oil has an ROCE of 13%. In absolute terms, that's a satisfactory return, but compared to the Oil and Gas industry average of 4.0% it's much better.
Above you can see how the current ROCE for Tullow Oil compares to its prior returns on capital, but there's only so much you can tell from the past. If you're interested, you can view the analysts predictions in our free report on analyst forecasts for the company.
What The Trend Of ROCE Can Tell Us
We're delighted to see that Tullow Oil is reaping rewards from its investments and has now broken into profitability. Historically the company was generating losses but as we can see from the latest figures referenced above, they're now earning 13% on their capital employed. Additionally, the business is utilizing 78% less capital than it was five years ago, and taken at face value, that can mean the company needs less funds at work to get a return. This could potentially mean that the company is selling some of its assets.
For the record though, there was a noticeable increase in the company's current liabilities over the period, so we would attribute some of the ROCE growth to that. Effectively this means that suppliers or short-term creditors are now funding 67% of the business, which is more than it was five years ago. Given it's pretty high ratio, we'd remind investors that having current liabilities at those levels can bring about some risks in certain businesses.
The Key Takeaway
In a nutshell, we're pleased to see that Tullow Oil has been able to generate higher returns from less capital. Given the stock has declined 66% in the last five years, this could be a good investment if the valuation and other metrics are also appealing. So researching this company further and determining whether or not these trends will continue seems justified.
One more thing to note, we've identified 1 warning sign with Tullow Oil and understanding it should be part of your investment process.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
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