Investors expect good returns. The more cash you get back for the amount you invested, the better your investment. The same applies to businesses themselves. So how do we find out whether a business can earn superior returns from its own investments?
The metric that matters: return on invested capital
Growing bottom lines do no always guarantee good returns. It pays to find out how much the company has invested to create that earnings growth -- which is where return on invested capital, or ROIC, comes into play.
Oil and gas companies, in general, have faced tough times in the last five years. Volatile energy prices have obviously contributed to their fluctuating returns. But during this time, companies have sunk a lot of cash into investments whose gains haven't yet fully materialized. Investments in Bakken and Eagle Ford shale plays, for example, are still relatively immature. However, like many North American oil and gas plays, these investments have begun to bear fruit in the last couple of years.
Still, Foolish investors should know which companies are getting the most impressive returns compared to their invested capital. The following energy companies show huge future potential and get great value for the money they've spent:
This behemoth has traditionally been among the best in the business at generating returns. Its ROIC stands at 13%, surpassing all its industry peers. This is fairly astounding considering the scale of Exxon's operations. Its ROIC's improvement from the previous year's 12% indicates bigger growth in operating profits when compared against invested capital.
Net operating profits after adjusting for taxes, or NOPAT, rose by 51% year over year, while invested capital saw a comparatively lower 36% increase. The company's average cash conversion cycle, or CCC, also dropped to -21.7 days, from -20.5 days in the corresponding period last year. (That's a good thing.) I believe this company will generate even higher returns once natural gas is back in favor; Exxon's recent investments in that sector have yet to bear fruit.
2. Southwestern Energy
This natural gas producer's ROIC has gradually slipped over the last three years. Still, its current value of 12% is none too shabby. Bearish market conditions for natural gas have taken their toll on Southwestern, but as gas demand picks up again, I believe a rebound is only a matter of time.
3. Occidental Petroleum
Impressive first-quarter results fueled by high oil prices have definitely helped this company boost earnings. Current ROIC stands at 12%, which improved a tad from 11% the previous year, but part of a series of ups and downs over the past five years. Higher production will definitely help this $86 billion company compete better against the Big Three in the E&P business.
One leg of the Big Three, this integrated giant's ROIC currently stands at a little more than 12%. This is a huge improvement from less than 9% a year ago. The company's year-over-year average CCC fell from 6.3 days to 2.0 days (again, a good thing). NOPAT grew 54%, on an invested capital growth of just 11% in the same period. That metric's currently nearing a five-year high.
Now the world's fastest-growing LNG producer, Chevron's leading the race to exploit the imminent natural gas boom. Its $45 billion LNG project off Western Australia is on course for first gas in 2014.
5. Ultra Petroleum
This company's management is obsessed with generating great returns. Current ROIC impressively stands at a little more than 11%. Average CCC dropped to -172 days, from -153 days a year ago. Foolish colleague Dan Dzombak previously explained how Ultra creates value by keeping a lid on production costs despite a bearish natural gas market.
6. Marathon Oil
With an ROIC slightly less than 11%, this integrated company has been consolidating. The company's current CCC of 2.3 days is the lowest it has been in the last six years. Now that it's spinning off subsidiary Marathon Petroleum, Marathon Oil could enjoy substantial efficiency growth in the coming years.
This company bought more than $11 billion in natural gas assets in 2010 alone, driving its ROIC below 10% for the first time in four years. However, once demand for gas picks up, these investments could generate solid returns.
The Foolish bottom line
Moreso than ROE or ROC, returns on invested capital better measure actual returns from a company's financial choices. All seven of the stocks above have passed this crucial test, and on this metric alone, at least, they might merit Fools' attention.
Fool contributor Isac Simon does not own shares of any of the companies mentioned in this article. The Motley Fool owns shares of Ultra Petroleum. Motley Fool newsletter services have recommended buying shares of Chevron. Motley Fool newsletter services have recommended writing puts in Southwestern Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.