Return on average capital employed has emerged as a key measure of efficiency in capital-intensive industries, especially in the energy sector. However, what initially seems to be a relatively easy measure becomes complicated given the differences in how various companies calculate these returns.
After a perusal of the annual reports of the major integrated oil and gas firms, this becomes apparent with some firms giving quite different results for their return on (average) capital employed (ROACE). So, finding the ROACE on company balance sheets, and directly comparing these figures, will not give you an accurate understanding of capital efficiency between two or more firms.
But, this measure is a very useful piece of information to have in an investor’s toolbox. So, if you want to compare companies using this valuable measure, you will first need to standardize the calculations and the data between the companies in order to have an apples-to-apples comparison. The simplest approach in a situation like this is to find the most appropriate amount of commonality and overlap between the various approaches employed, and go from there. And, many of the integrated firms do have significant overlap.
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Return on capital employed, or return on average capital employed, in the most basic sense, is earnings before interest and tax (EBIT) divided by total capital employed. This is the core textbook definition, and can certainly be used for a basic ROCE comparison between companies; however, the oil firms have a slightly different approach that ultimately changes the outcome by a significant margin.
Let’s have a look at the annual reports from ExxonMobil (XOM), Shell (RDS.A), and Conoco Phillips(COP). In Exxon’s Annual Report companion, the 2014 Financial Statements and Supplemental Information document, page 5 has a detailed look at their explanation of ROCE (you need ROCE before you can calculate ROACE). It is the “annual business segment earnings divided by average business segment capital employed (average of beginning and end-of-year amounts) … The Corporation’s total ROCE is net income attributable to ExxonMobil excluding the after-tax cost of financing divided by total corporate average capital employed.”
Shell’s ROACE on page 51 of their 2014 Annual Report is “defined as income for the period adjusted for after-tax interest expense as a percentage of the average capital employed for the period … Capital employed consists of total equity, current debt and non-current debt.” And, Conoco doesn’t provide a full explanation, except to state, capital employed is “total equity plus total debt” in a footnote on page 13 of their 2014 Annual Report.
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These statements are generally similar, but when you look at how they calculate each component, some inconsistencies arise.
Some include “special items” and one-time expenses. Others include other figures like “third party debt” and various approaches to determining the correct interest expenses to be integrated into the measure. As compared to the core definition, one of the most crucial changes is the use of net income, instead of EBIT, and capital employed is still generally either total assets less all current liabilities or stockholder’s equity plus non-current liabilities.
Now, instead of digging through all the balance sheets of the companies you intend to examine, an easier approach to using this metric is to simply go to a site where income and balance sheet data is already aggregated and standardized across all companies in question. The other trick is to find this data going back far enough so you can spot trends in your target companies, and understand their long-term utilization of capital.
These firms also tend to get very specific with their after tax interest expenses. This figure is typically quite small, so if you’re looking for a basic comparison, you can go ahead and exclude it. However, if you’re doing a detailed analysis, you will need to go in and find the interest expenses that are appropriate for the ROACE calculation in the company income statements.
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So, a good compromise to find ROCE based on the methods employed by the companies, the textbook definition, and data availability is:
This gives you your core ROCE measure, and then to get “average” capital, you simply average the current and previous year’s capital employed, and use that as your denominator to arrive at ROACE. The chart below shows the ROACE of the three companies mentioned, using this standardized approach:
With a standard measure in place, we can confidently state that ExxonMobil is the clear, and consistent, winner in capital efficiency, holding that top spot for at least the past five years. Conoco is consistent, but still lags behind ExxonMobil. Shell shows perhaps a higher degree of inconsistency, and has dipped into the single digits in 2013 and 2014.
Coupled with other data and measures, ROCE/ROACE provides extremely useful information that delivers a higher level of accuracy in determining energy company profitability, and more broadly in determining investment feasibility. But as with many measures, the details can vary, and due diligence must be conducted in order to have an accurate picture in determining whether or not to invest in a particular firm.
By Ryan Opsal for Oilprice.com
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