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 don't 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 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 causing fluctuating bottom lines. But these companies have sunk a lot of cash into investments by raising debt and by equity. Therefore, it makes economic sense to find out whether these investments are generating the returns that investors expect. Today, we'll see how ATP Oil & Gas
This is how invested capital, operating income, and ROIC stack up for the past six years:
Sources: S&P Capital IQ. 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 shown steady growth in the past five years while returns have been diminishing. Returns have been negative for the past three years. The company has been hit badly by the moratorium in the Gulf of Mexico, which holds 66% of its reserves. But that's just the story in the past 18 months. Since June 2007, net value of property, plant, and equipment has nearly doubled from $1.5billion to $2.9 billion. However, operating losses have marred the company for the past three years. ATP has acquired a lot of properties; however, with 81% of its reserves undeveloped, the company has a tall order ahead.
In terms of competition, this is how ATP stacks up.
|ATP Oil & Gas||(1.6%)||(85.3%)|
Magnum Hunter Resources
Source: S&P Capital IQ; ROIC is author's calculation; TTM = trailing 12 Months.
Compared with its peers, ATP's returns don't look too 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 (WACC) tells us exactly that, since both debt and equity are used for financing operations. Debt to equity currently stands at 608%. This is again alarmingly high.
ATP's after-tax interest expense or cost of debt stands at $199 million for the trailing-12-month period, which is more than 10% 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 10.3%, which is way higher than the ROIC of -1.6%. This is a potential red flag. ATP hasn't really been able to build shareholder value. The company has been investing in projects whose current returns are below 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. Still, investors can avoid possible pitfalls by finding out whether the company is capable of growing economically.
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