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Today we are going to look at Extraction Oil & Gas, Inc. (NASDAQ:XOG) to see whether it might be an attractive investment prospect. To be precise, we’ll consider its Return On Capital Employed (ROCE), as that will inform our view of the quality of the business.
First, we’ll go over how we calculate ROCE. Second, we’ll look at its ROCE compared to similar companies. Finally, we’ll look at how its current liabilities affect its ROCE.
Understanding Return On Capital Employed (ROCE)
ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. Generally speaking a higher ROCE is better. 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 Extraction Oil & Gas:
0.032 = US$117m ÷ (US$4.1b – US$429m) (Based on the trailing twelve months to March 2019.)
Therefore, Extraction Oil & Gas has an ROCE of 3.2%.
Does Extraction Oil & Gas Have A Good ROCE?
When making comparisons between similar businesses, investors may find ROCE useful. In this analysis, Extraction Oil & Gas’s ROCE appears meaningfully below the 7.4% average reported by the Oil and Gas industry. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Independently of how Extraction Oil & Gas compares to its industry, its ROCE in absolute terms is low; especially compared to the ~2.7% available in government bonds. It is likely that there are more attractive prospects out there.
Extraction Oil & Gas has an ROCE of 3.2%, but it didn’t have an ROCE 3 years ago, since it was unprofitable. That suggests the business has returned to profitability.
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. ROCE is only a point-in-time measure. We note Extraction Oil & Gas could be considered a cyclical business. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Extraction Oil & Gas.
How Extraction Oil & Gas’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 counteract this, we check if a company has high current liabilities, relative to its total assets.
Extraction Oil & Gas has total liabilities of US$429m and total assets of US$4.1b. Therefore its current liabilities are equivalent to approximately 10% of its total assets. This is a modest level of current liabilities, which will have a limited impact on the ROCE.
Our Take On Extraction Oil & Gas’s ROCE
Extraction Oil & Gas has a poor ROCE, and there may be better investment prospects out there. Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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 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.