Ah, so that was February. The month where the attention of a weather-beaten and winterized nation turns to glorious leaders from yesteryear (President's Day), loves lost and hearts burning anew (St. Valentine's Day), and a media-hyped marmot (Groundhog Day). All of this in a mere 28 days, 29 at the most.
Alas, our splendid month of February has already come and gone, relinquishing the reins of Father Time's ever-charging team of Percherons to the foggy and dewy early-spring splendor of March. And we all know what gift March brings to the world:
Yes, college basketball's annual bacchanal is coming soon to a TV set near you. Here at the Drip Port, we're getting ready for some March Madness of our own. After discussing enterprise value and free cash flow, we're driving the lane and closing in on a handy investment performance measure: Return on capital employed, or ROCE. (By the way, we like to pronounce ROCE as "Roc-E." As in Rocky "Yo, Adrian!" Balboa, one of Jeff's childhood heroes.)
We've discovered that ROCE is a telling and straightforward gauge for comparing the relative profitability levels of companies. However, the road to understanding ROCE can be, well, rocky. We define ROCE as after-tax operating profits divided by the sum of total debt plus shareholders' equity. This may sound fairly simple, but in the complex financial statements of many companies today, deriving an accurate number from this formula can be more challenging than squeezing oil from a rock.
First, a brief review of why ROCE is so important. It's mainly important in industries that invest a good deal of capital in the business-- such as oil and gas giants, semiconductor chip companies, and even food giants. ROCE is, actually, the oil and gas industry's preferred benchmark for comparing one company's performance to another, bar none. If we had to decide whether to place money in an oil and gas company based on a single data point alone (not a Foolish idea, mind you), we would choose ROCE over the P/E ratio, dividend yield, book value, share price, or any other piece of information out there any day of the week.
It's important to know what analytical function ROCE serves. This ratio shows how much money is coming out of a business relative to how much moolah is going in. It resembles its better-known cousin, Return on Invested Capital (ROIC). (For a superb introduction to the strengths of ROIC as an analytical tool, click here.)
Our ROCE guinea pig will be giant Exxon-Mobil (NYSE: XOM). To keep things simple, we'll look at the denominator first, using data from the liabilities portion of the balance sheet included in Exxon's latest form 10-K, which is the annual report (the latest one available is the 10-K for the year ended December 2000, dated March 31, 2001 -- it serves our purpose).
(in millions of $) Current liabilities Notes and loans payable: 6,161 Accounts payable and accrued liabilities: 26,755 Income taxes payable: 5,275 Other liabilities Long-term debt: 7,820 Annuity reserves and accrued liabilities: 11,934 Deferred income tax liabilities: 16,442 Deferred credits: 1,166 Equity of minority interest in affiliates: 3,230 Total shareholders' equity: 70,757
Right away, we know how much shareholders' equity the company has at its disposal. Finding how much total debt Exxon-Mobil uses to fund its operations is not quite so clear-cut. Long-term debt definitely must be factored in, but what other liabilities should be included? Notes and loans payable is actually another phrase for short-term debt. While often we will ignore short-term debt and focus on longer-term maturities when looking at a company's leverage, here short-term debt must be included. Exxon-Mobil uses those notes and loans for whichever part of its business has short-term funding needs. So, into ROCE it goes.
Finally, the equity of minority interest in affiliates line should also be thought of as part of the firm's equity capital. This item represents the equity of Exxon-Mobil's business partners' in combined ventures around the globe. Joint ventures and other such business combinations are common in the oil and gas industry, so this item will appear on a lot of balance sheets. It's equity that is being employed by Exxon-Mobil, in an accounting way of thinking, so it should be included in ROCE.
So, our denominator comes out like this:
70,757 + 7,820 + 6,161 + 3,230 = 87,968
Now, onto the income statement to find a numerator:
Total revenue: 232,748 Costs Crude oil and product purchases: 108,951 Operating expenses: 18,135 SG&A expenses: 12,044 Depreciation and depletion: 8,130 Exploration expenses: 936 Interest expense: 589 Excise taxes: 22,356 Other taxes and duties: 32,708 Income applicable to minority interests: 412
Total Costs: 205,667 Income before income taxes: 27,081 Income taxes: 11,091 Net income: 15,990
We're looking for after-tax operating earnings for our numerator. Often, we can use net income for this number. However, Exxon-Mobil has the income applicable to minority interests under the costs heading of the income statement. This is the company's way of expressing how much of its earnings from those equity interests must be "paid out" to its partners. We're going to add this back into income before income taxes to show all of the company's profits from the capital it is employing, just to keep things consistent.
For our purposes, then, income before income taxes is 27,081 + 412 = 27,493
Exxon-Mobil's income tax rate last year was 40.9% (11,091 divided by 27,081). Multiplying the adjusted income before the income taxes figure found above (27,493) by the inverse of Exxon's tax rate (0.591) gives us after-tax operating earnings of 16,248 (or $16.24 billion).
That's our numerator -- 16,248.
Finally, putting the numerator and denominator together gives us ROCE of 18.4% (16,248 divided by 87,958). ROCE is up significantly from Exxon's 15.5% ROCE in 1998 (a tough year for oil prices) before it merged with Mobil.
One last thought on deriving after-tax operating earnings for use in ROCE with oil stocks. Asset writedowns and extraordinary losses due to low oil and gas prices, when they occur, should not be included in the numerator of your ROCE calculations.
Reading this column, you might seem overwhelmed by the mathematics. But if you pull up a 10-K for an appropriate company that you own and follow the instructions here, step by step, for finding the numerator and denominater for ROCE, we believe that you'll find that it's really not too difficult. Once you start figuring ROCE for the appropriate companies in your portfolio, as with free cash flow, you can begin to track results annually and you will be that much better armed to spot possible trouble before everyone else does.
Brian Graney is a former Fool writer who continues to work in the investment industry. Jeff Fischer is the Drip Port's manager currently on leave, so he did this math in January. He doesn't own shares in Exxon-Mobil -- his profile shows the stocks he owns. The Fool has a disclosure policy.