Investors pondering their choices as oil prices continue to recover must attempt to determine which firms are the best investments. The problem is that every company management team is trying to put the best spin on their results in quarterly conference calls and investor presentations. As a result, sage investors should take a careful look at more objective measures of value and success in firms. One of the best metrics for doing that is Return on Invested Capital or ROIC.
ROIC has recently become a much more popular metric on Wall Street, and that’s good for investors. ROIC can be complex to calculate, but essentially it is just a measure of how efficient a company is with respect to its capital. The formula divides cash flow by a company’s equity and debt less its cash balance. Firms which earn high margins and use their assets effectively are rewarding investors and earning a high ROIC. Such efficiency has been rare among many oil companies, which spent years wasting capital drilling wells with questionable long run economics.
Using ROIC as an investing metric can be lucrative for investors. Stocks in the highest quintile of ROIC over the last 12 years had an average stock price return of 10.5 percent annually while firms in the lowest quintile had an average stock price return of 8.1 percent.
Similarly, oil companies can also reduce their required assets through off balance sheet transactions that give them low cost sources of funding such as off-balance sheet greenfield investments with retained usage rights through tolling. These types of transactions give firms effective control over an asset’s capacity without tying up full capital funding. These types of transactions, along with various working capital related financial structures, can reduce capital employed by as much as 20 percent in some instances. While capital light balance sheet structures do require robust enterprise risk management methods, they are an effective tool in boosting returns.
Finally, firms can increase their margins through effective joint ventures and M&A deals that help sustain reserve-replacement ratios. These deals are particularly attractive at present given the current state of the industry. Value engineering and capital optimization techniques make these deals potentially even more attractive.
All three methods of boosting ROIC can enhance the attractiveness of a firm to investors and lenders. Given present industry circumstances, lenders are only interested in working with the most stable and efficient firms. ROIC is a useful metric to demonstrate that stability.
The point here is that ROIC is a metric that both firms and investors should care about. The levers to pull on ROIC are not as simple as the manipulation that can be done with EPS, but they are worthwhile endeavors that can help firms to run more efficiently and boost returns for shareholders as well.
By Michael McDonald of Oilprice.com