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Today we’ll look at PetroChina Company Limited (HKG:857) and reflect on its potential as an investment. Specifically, we’ll consider its Return On Capital Employed (ROCE), since that will give us an insight into how efficiently the business can generate profits from the capital it requires.
Firstly, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. And finally, we’ll look at how its current liabilities are impacting its ROCE.
What is Return On Capital Employed (ROCE)?
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. In general, businesses with a higher ROCE are usually better quality. 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’.
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 PetroChina:
0.072 = CN¥149b ÷ (CN¥2.6t – CN¥568b) (Based on the trailing twelve months to March 2019.)
So, PetroChina has an ROCE of 7.2%.
Is PetroChina’s ROCE Good?
One way to assess ROCE is to compare similar companies. We can see PetroChina’s ROCE is meaningfully below the Oil and Gas industry average of 11%. This performance is not ideal, as it suggests the company may not be deploying its capital as effectively as some competitors. Separate from how PetroChina 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.
As we can see, PetroChina currently has an ROCE of 7.2% compared to its ROCE 3 years ago, which was 3.6%. 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 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 PetroChina are cyclical businesses. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.
What Are Current Liabilities, And How Do They Affect PetroChina’s ROCE?
Liabilities, such as supplier bills and bank overdrafts, are referred to as current liabilities if they need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
PetroChina has total assets of CN¥2.6t and current liabilities of CN¥568b. As a result, its current liabilities are equal to approximately 22% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.
What We Can Learn From PetroChina’s ROCE
That said, PetroChina’s ROCE is mediocre, there may be more attractive investments around. You might be able to find a better investment than PetroChina. 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).
I will like PetroChina 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.