Investors expect good returns. The more cash you get back for the amount you invested, the better your investment is. The same holds 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 don't always guarantee good returns. More than earnings growth itself, it pays to find out how much has been invested into the business to generate that growth. This is where return on invested capital (ROIC) 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 ROIC might be declining. In other words, for every dollar of income generated, the company has to plow 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 past five years. Volatility in energy prices has played a role in fluctuating bottom lines. But 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'll see how Newfield Exploration
This is how invested capital, operating income, and ROIC stack up for the past six years.
Source: Capital IQ, a division of Standard & Poor's. ROIC is author's calculation. All data presented is for a 12-month period, ending June 30 of the corresponding year.
Returns on invested capital have been declining drastically in the last couple of years, while capital employed has been going up steadily. As I've noted before, capital and service costs involving the company's Williston Basin and Eagle Ford projects have shot up because of rising inflationary pressures in these hot plays.
While this should actually be good news for the long term, management intends to bring down costs by limiting activities in these shale plays. With a declining operating income, this is definitely a potential yellow flag. Newfield's management should work harder to increase shareholder returns.
In terms of competition, here's how Newfield stacks up.
Return on Invested Capital (ROIC) (TTM)
Return on Equity (ROE) (TTM)
Source: Capital IQ, a division of Standard & Poor's; ROIC is author's calculation; TTM = trailing 12 months.
Newfield's current returns aren't too impressive compared with those of its peers.
What's the return compared with 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 (WACC) tells us exactly that, since both debt and equity are used for financing operations. Debt-to-equity currently stands at 81.1%.
Newfield's after-tax interest expense or cost of debt stands at $58 million for the trailing-12-month period, which is 2% of its total debt. Expecting a 15% return from equity (beating the S&P 500's average 10% average historical return) is a fair expectation for this company, given the risks involved in the shale plays and the natural gas market.
Using this data, WACC adds up to 4.5%. This is less than the ROIC of 5.8%, which is what I'm looking for. Newfield 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 are yet to fully realize gains. Investments in the Bakken and Eagle Ford shale plays, for example, are still relatively immature. Still, investors can avoid possible pitfalls by finding out whether the company is capable of growing economically.
Add Newfield Exploration to My Watchlist.
Fool contributor Isac Simon owns no shares of any of the companies mentioned in this article. The Motley Fool owns shares of Denbury Resources. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.