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Why We Like Gulf Keystone Petroleum Limited’s (LON:GKP) 7.0% Return On Capital Employed

Arjun Bhatia

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Today we are going to look at Gulf Keystone Petroleum Limited (LON:GKP) 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 of all, we’ll work out how to calculate ROCE. Next, we’ll compare it to others in its industry. 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 metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its 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 Gulf Keystone Petroleum:

0.07 = US$23m ÷ (US$708m – US$87m) (Based on the trailing twelve months to June 2018.)

Therefore, Gulf Keystone Petroleum has an ROCE of 7.0%.

See our latest analysis for Gulf Keystone Petroleum

Is Gulf Keystone Petroleum’s ROCE Good?

ROCE is commonly used for comparing the performance of similar businesses. Using our data, we find that Gulf Keystone Petroleum’s ROCE is meaningfully better than the 5.3% average in the Oil and Gas industry. We would consider this a positive, as it suggests it is using capital more effectively than other similar companies. Setting aside the industry comparison for now, Gulf Keystone Petroleum’s ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.

Gulf Keystone Petroleum has an ROCE of 7.0%, but it didn’t have an ROCE 3 years ago, since it was unprofitable. That suggests the business has returned to profitability.

LSE:GKP Last Perf February 10th 19

It is important to remember that ROCE shows past performance, and is not necessarily predictive. 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 Gulf Keystone Petroleum could be considered a cyclical business. Future performance is what matters, and you can see analyst predictions in our free report on analyst forecasts for the company.

Gulf Keystone Petroleum’s Current Liabilities And Their Impact On Its ROCE

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. 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.

Gulf Keystone Petroleum has total liabilities of US$87m and total assets of US$708m. As a result, its current liabilities are equal to approximately 12% of its total assets. This is a modest level of current liabilities, which would only have a small effect on ROCE.

Our Take On Gulf Keystone Petroleum’s ROCE

If Gulf Keystone Petroleum continues to earn an uninspiring ROCE, there may be better places to invest. You might be able to find a better buy than Gulf Keystone Petroleum. 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).

I will like Gulf Keystone Petroleum better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.