Are Dongyang E&P Inc.’s (KOSDAQ:079960) High Returns Really That Great?

Today we'll look at Dongyang E&P Inc. (KOSDAQ:079960) and reflect on its potential as an investment. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First up, we'll look at what ROCE is and how we calculate it. Next, we'll compare it to others in its industry. Last but not least, we'll look at what impact its current liabilities have on 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. All else being equal, a better business will have a higher ROCE. Ultimately, it is a useful but imperfect metric. 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 Dongyang E&P:

0.098 = ₩23b ÷ (₩315b - ₩80b) (Based on the trailing twelve months to September 2019.)

Therefore, Dongyang E&P has an ROCE of 9.8%.

Check out our latest analysis for Dongyang E&P

Is Dongyang E&P's ROCE Good?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that Dongyang E&P's ROCE is meaningfully better than the 7.3% average in the Electrical industry. We consider this a positive sign, because it suggests it uses capital more efficiently than similar companies. Aside from the industry comparison, Dongyang E&P's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.

Our data shows that Dongyang E&P currently has an ROCE of 9.8%, compared to its ROCE of 7.5% 3 years ago. This makes us think about whether the company has been reinvesting shrewdly. You can see in the image below how Dongyang E&P's ROCE compares to its industry. Click to see more on past growth.

Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. 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. You can check if Dongyang E&P has cyclical profits by looking at this free graph of past earnings, revenue and cash flow.

How Dongyang E&P'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 counteract this, we check if a company has high current liabilities, relative to its total assets.

Dongyang E&P has total assets of ₩315b and current liabilities of ₩80b. Therefore its current liabilities are equivalent to approximately 25% of its total assets. It is good to see a restrained amount of current liabilities, as this limits the effect on ROCE.

Our Take On Dongyang E&P's ROCE

That said, Dongyang E&P's ROCE is mediocre, there may be more attractive investments around. You might be able to find a better investment than Dongyang E&P. 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 Dongyang E&P better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

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. Thank you for reading.