Investors expect good returns. The more cash you get back for the amount you invested, the better your investment is. Same is true for the company you invest in. So, how do we find out whether a business is capable of generating superior returns?
The metric that matters: return on invested capital
Growing bottom lines do not always guarantee good returns. More than earnings growth itself, it pays to find out how much has been invested in the business in order to generate that growth. This is where return on invested capital comes into play.
ROIC looks at earnings power relative to how much capital is tied up in a business. While a company's earnings may register growth, the return on invested capital might be declining. In other words, for every dollar of income generated, the company has to plough in more and more cash into the business over time. This is a warning sign. Unfortunately, investors fall into the trap of putting cash into companies that venture into less profitable projects. The result: It requires more cash for the company to generate the same returns.
Oil and gas companies have been through some tough times in the last five years. Volatility in energy prices has played a role in causing fluctuating bottom lines. But the fact is, these companies have sunk a lot of cash into investments by raising debt and by raising equity. Therefore, it makes more economic sense to find out whether these investments are generating returns that investors expect. Today, we will see how ExxonMobil
This is how invested capital, operating income and ROIC stack up for the past six years:
Source: Capital IQ, a Standard & Poor's company. ROIC is author's calculation. All data presented here is for a 12-month period, ending June 30 of the corresponding year.
Invested capital has shot up by 60% since 2008, while ROIC has fallen by more than half since then. While this decrease has been the general trend in the exploration and production space since the global downturn, it's definitely a yellow flag. Operating income, too, has been declining in the last three years. Exxon's management could probably work more to increase shareholder value.
However, in the last 12 months, operating income has grown faster than capital employed, which has pushed up the ROIC. This does look encouraging.
In terms of competition, this is how Exxon stacks up:
Return on Invested Capital
Return on Equity
Royal Dutch Shell
Source: Capital IQ, a Standard & Poor's company.
Compared to its peers, Exxon's returns look pretty impressive.
What's the return compared to the cost?
Unfortunately, ROIC alone can't tell you how well a company is operating. Invested capital comes at a cost. Investors should check whether returns on invested capital exceed that cost. The weighted average cost of capital, or WACC, tells us exactly that, since both debt and equity are used for financing operations. Debt-to-equity currently stands at 10.2%.
Exxon's after-tax interest expense or cost of debt stands at $149 million for the trailing-12-month period, which is less than 1% of its total debt. Expecting a 12% return from equity (beating the S&P 500's average 10% average historical return) is a fair expectation for this company.
Using this data, WACC adds up to 10.9%. This is less than the ROIC of 13.2%, which is what I'm looking for. Exxon has been able to build on shareholder value. The company has been investing in projects that generate returns above the rate investors expect.
Foolish bottom line
Exploration and production companies have sunk a lot of cash into investments during the past few years, on which they have yet to fully realize gains. Investments in Bakken and Eagle Ford shale plays, for example, are still relatively immature. However, investors can avoid possible pitfalls by finding out whether the company is capable of growing economically.
- Add ExxonMobil to My Watchlist.
Fool contributor Isac Simon does not own shares of any of the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Chevron. 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.