Why Centennial Resource Development, Inc.’s (NASDAQ:CDEV) Return On Capital Employed Might Be A Concern

Today we'll look at Centennial Resource Development, Inc. (NASDAQ:CDEV) 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.

Understanding Return On Capital Employed (ROCE)

ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. Generally speaking a higher ROCE is better. In brief, it is a useful tool, but it is not without drawbacks. 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?

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 Centennial Resource Development:

0.018 = US$79m ÷ (US$4.7b - US$254m) (Based on the trailing twelve months to December 2019.)

So, Centennial Resource Development has an ROCE of 1.8%.

See our latest analysis for Centennial Resource Development

Does Centennial Resource Development Have A Good ROCE?

One way to assess ROCE is to compare similar companies. Using our data, Centennial Resource Development's ROCE appears to be significantly below the 6.8% average in the Oil and Gas industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Putting aside Centennial Resource Development's performance relative to its industry, its ROCE in absolute terms is poor - considering the risk of owning stocks compared to government bonds. There are potentially more appealing investments elsewhere.

Centennial Resource Development reported an ROCE of 1.8% -- better than 3 years ago, when the company didn't make a profit. This makes us wonder if the company is improving. You can click on the image below to see (in greater detail) how Centennial Resource Development's past growth compares to other companies.

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. 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. Given the industry it operates in, Centennial Resource Development could be considered cyclical. Since the future is so important for investors, you should check out our free report on analyst forecasts for Centennial Resource Development.

What Are Current Liabilities, And How Do They Affect Centennial Resource Development'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. 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 counter this, investors can check if a company has high current liabilities relative to total assets.

Centennial Resource Development has total assets of US$4.7b and current liabilities of US$254m. As a result, its current liabilities are equal to approximately 5.4% of its total assets. Centennial Resource Development has a low level of current liabilities, which have a negligible impact on its already low ROCE.

Our Take On Centennial Resource Development's ROCE

Nevertheless, there are potentially more attractive companies to invest in. But note: make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

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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.