Investors expect good returns. The more cash you get back for the amount you invested, the better your investment is. The 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 into the business in order 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 return on invested capital might be declining. In other words, for every dollar of income generated, the company has to plough 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 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. It makes economic sense to find out whether these investments are generating returns that investors expect. Today, we will see how Occidental Petroleum
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 are for a 12-month period, ending June 30 of the corresponding year.
Invested capital has shown steady growth in the past five years, while returns have been fluctuating. However, the past 24 months have shown a steady growth in returns. Occidental's cost-effective strategy to increase production through enhanced oil recovery in mature and underdeveloped fields makes it attractive.
Enhanced oil recovery is a technique in which carbon dioxide is injected into oil reservoirs, causing the oil to flow more freely into producing wells. This helps recover oil that is unobtainable using conventional methods. Occidental uses this technique in its Permian Basin properties, which have more than 1.2 billion barrels of oil equivalent (BOE) in reserves.
This is how Occidental stacks up to the competition:
Return on Invested Capital
Return on Equity (TTM)
Canadian Natural Resources
Source: Capital IQ, a Standard & Poor's company; ROIC is author's calculation; TTM = trailing 12 months.
Compared to its peers, Occidental's returns look the best.
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 (WACC) tells us exactly that since both debt and equity are used for financing operations. Debt-to-equity currently stands at 12.1%.
Occidental's after-tax interest expense or cost of debt stands at $182 million for the trailing-12-month period, which is more than 4% 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 given the risks involved in the shale plays and the natural gas market.
Using this data, WACC adds up to 11.1%, which is less than the ROIC of 14.5%, which is what I'm looking for. Occidental has been able to build on shareholder value. The company has been investing in projects which generate returns that are above the rate investors expect.
Foolish bottom line
During the past few years, exploration and production companies have sunk a lot of cash into investments on which they are yet to fully realize gains. The low-risk, high-yielding methods used in oil recovery should fetch returns that more than cover the costs involved. Still, investors can avoid possible pitfalls by finding out whether the company is capable of growing economically. To stay up-to-date on Occidental, add the stock to your free, personalized watchlist.
Fool contributor Isac Simon does not own shares of any of the companies mentioned in this article. 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.