Today we’ll look at Diamondback Energy, Inc. (NASDAQ:FANG) and reflect on its potential as an investment. 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.
Firstly, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. 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 is a measure of a company’s yearly pre-tax profit (its return), relative to the capital employed in the 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 Diamondback Energy:
0.069 = US$1.5b ÷ (US$24b – US$1.2b) (Based on the trailing twelve months to September 2019.)
So, Diamondback Energy has an ROCE of 6.9%.
Is Diamondback Energy’s ROCE Good?
ROCE is commonly used for comparing the performance of similar businesses. In this analysis, Diamondback Energy’s ROCE appears meaningfully below the 8.9% average reported by the Oil and Gas industry. This performance could be negative if sustained, as it suggests the business may underperform its industry. Setting aside the industry comparison for now, Diamondback Energy’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Readers may find more attractive investment prospects elsewhere.
Our data shows that Diamondback Energy currently has an ROCE of 6.9%, compared to its ROCE of 3.5% 3 years ago. This makes us wonder if the company is improving. You can click on the image below to see (in greater detail) how Diamondback Energy’s past growth compares to other companies.
When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. 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. Remember that most companies like Diamondback Energy are cyclical businesses. Since the future is so important for investors, you should check out our free report on analyst forecasts for Diamondback Energy.
How Diamondback Energy’s Current Liabilities Impact Its ROCE
Current liabilities are short term bills and invoices that need to be paid in 12 months or less. Due to the way ROCE is calculated, a high level of current liabilities makes a company look as though it has less capital employed, and thus can (sometimes unfairly) boost the ROCE. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.
Diamondback Energy has total liabilities of US$1.2b and total assets of US$24b. As a result, its current liabilities are equal to approximately 5.0% of its total assets. Diamondback Energy reports few current liabilities, which have a negligible impact on its unremarkable ROCE.
The Bottom Line On Diamondback Energy’s ROCE
If performance improves, then Diamondback Energy may be an OK investment, especially at the right valuation. You might be able to find a better investment than Diamondback Energy. 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).
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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.
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