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 Talisman Energy (NYSE: TLM) stacks up in this regard.

This is how invested capital, operating income and ROIC stack up for the past six years:

Source: S&P Capital IQ. ROIC is author's calculation. All data presented is for a 12-month period, ending Sept. 30 of the corresponding year.

Returns on invested capital have shown steady growth in the last 24 months. The company's North American shale projects were instrumental in this regard. The Eagle Ford and the Marcellus shale plays helped production average 78,000 barrels of oil equivalent per day (Boe/d) -- a whopping 178% growth from 2010. Talisman plans further development in these shale plays, which should further help increase returns.

In terms of competition, this is how Talisman stacks up.




Talisman Energy 8.2% (1.4%)
Southwestern Energy (NYSE: SWN) 13.4% 20.6%
EOG Resources (NYSE: EOG) 1.9% 3.7%
Chesapeake Energy (NYSE: CHK) 3.5% 7.4%

Source: S&P Capital IQ; ROIC is author's calculation; TTM = trailing 12 months.

Compared with its peers, Talisman's returns look decent. While the values aren't too bad, management could work harder to increase shareholder value, which I reckon should happen over time.

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 40.9%.

Talisman's after-tax interest expense or cost of debt stands at $107 million for the trailing-12-month period, which is less than 3% 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 9.3%, which is higher than the ROIC of 8.2%. This is a potential red flag. Talisman hasn't been able to build on shareholder value. The company has been investing in projects that generate returns that are below the rate investors expect. But this could reverse soon.

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.

Add Talisman Energy to My Watchlist.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.