Today we'll look at ARC Resources Ltd. (TSE:ARX) and reflect on its potential as an investment. 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. And finally, we'll look at how its current liabilities are impacting its ROCE.
Return On Capital Employed (ROCE): What is it?
ROCE is a measure of a company's yearly pre-tax profit (its return), relative to the capital employed in the business. In general, businesses with a higher ROCE are usually better quality. 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 ARC Resources:
0.04 = CA$220m ÷ (CA$5.8b - CA$360m) (Based on the trailing twelve months to September 2019.)
So, ARC Resources has an ROCE of 4.0%.
Does ARC Resources Have A Good ROCE?
One way to assess ROCE is to compare similar companies. We can see ARC Resources's ROCE is meaningfully below the Oil and Gas industry average of 5.4%. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Regardless of how ARC Resources stacks up against its industry, its ROCE in absolute terms is quite low (especially compared to a bank account). It is likely that there are more attractive prospects out there.
ARC Resources reported an ROCE of 4.0% -- better than 3 years ago, when the company didn't make a profit. This makes us wonder if the company is improving. The image below shows how ARC Resources's ROCE compares to its industry, and you can click it to see more detail on its past growth.
Remember that this metric is backwards looking - it shows what has happened in the past, and does not accurately predict the future. Companies in cyclical industries can be difficult to understand using ROCE, as returns typically look high during boom times, and low during busts. ROCE is, after all, simply a snap shot of a single year. We note ARC Resources could be considered a cyclical business. Since the future is so important for investors, you should check out our free report on analyst forecasts for ARC Resources.
How ARC Resources's Current Liabilities Impact Its ROCE
Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that 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 counter this, investors can check if a company has high current liabilities relative to total assets.
ARC Resources has total assets of CA$5.8b and current liabilities of CA$360m. As a result, its current liabilities are equal to approximately 6.2% of its total assets. With barely any current liabilities, there is minimal impact on ARC Resources's admittedly low ROCE.
Our Take On ARC Resources's ROCE
Still, investors could probably find more attractive prospects with better performance out there. You might be able to find a better investment than ARC Resources. 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).
If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
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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