Today we’ll evaluate Lundin Petroleum AB (publ) (STO:LUPE) to determine whether it could have potential as an investment idea. In particular, we’ll consider its Return On Capital Employed (ROCE), as that can give us insight into how profitably the company is able to employ capital in its business.
First of all, we’ll work out how to calculate ROCE. Next, we’ll compare it to others in its industry. And finally, we’ll look at how its current liabilities are impacting its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the ‘return’ (pre-tax profit) a company generates from 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’.
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 Lundin Petroleum:
0.25 = US$1.4b ÷ (US$5.8b – US$308m) (Based on the trailing twelve months to December 2018.)
Therefore, Lundin Petroleum has an ROCE of 25%.
Does Lundin Petroleum Have A Good ROCE?
One way to assess ROCE is to compare similar companies. Lundin Petroleum’s ROCE appears to be substantially greater than the 8.9% 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. Setting aside the comparison to its industry for a moment, Lundin Petroleum’s ROCE in absolute terms currently looks quite high.
Lundin Petroleum reported an ROCE of 25% — better than 3 years ago, when the company didn’t make a profit. That implies the business has been improving.
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. ROCE is, after all, simply a snap shot of a single year. Given the industry it operates in, Lundin Petroleum could be considered cyclical. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Lundin Petroleum.
What Are Current Liabilities, And How Do They Affect Lundin Petroleum’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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Lundin Petroleum has total liabilities of US$308m and total assets of US$5.8b. Therefore its current liabilities are equivalent to approximately 5.3% of its total assets. Modest current liabilities are not boosting Lundin Petroleum’s very nice ROCE.
Our Take On Lundin Petroleum’s ROCE
This suggests the company would be worth researching in more depth. Of course you might be able to find a better stock than Lundin Petroleum. So you may wish to see this free collection of other companies that have grown earnings strongly.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.