News that Royal Dutch Shell is buying gas group BG for £47bn has set investors salivating for more consolidation among oil & gas producers.
Still, it would be wise to choose carefully when assessing the prospects of a plethora of other potential takeover targets. For every billion pound behemoth churning out cash, there are many minnows destroying capital in the search for growth.
Therefore caution should be the watchword, and investors new to this sector should be very wary of buying shares indiscriminately in the hope of making a quick profit.
Return on capital employed (ROCE) is a useful metric to use when assessing the quality of any prospective share purchase as it enables an investor to compare profitability across companies based on the amount of capital they use.
Return on capital is used by Joel Greenblatt to identify good businesses in his popular book “The Little Book That Beats the Market” (John Wiley & Sons, 2006).
As defined by Greenblatt and others, is calculated as follows:
ROCE = Earnings before interest and tax (EBIT)/tangible capital employed
Where tangible capital employed = adjusted net working capital + net fixed assets.
[‘Adjusted net working capital’ is usually defined as current assets less current liabilities. Although, the focus can be narrowed to accounts receivable, inventory and cash needed to conduct business less accounts payable. While ‘net fixed assets’ are defined as property, plant and equipment less accumulated depreciation.]
Mercifully, you don’t need to do the calculation yourself. A quick trawl through Company REFS found oil & gas producers in the FTSE All-Share ranked in order of ROCE. A higher ROCE indicates more efficient use of capital.
|Nostrum Oil & Gas||19.8|
|Royal Dutch Shell||13.2|
|Europa Oil & Gas||7.88|
|Trinity Exploration & Production||4.23|
|JKX Oil & Gas||1.72|
Source: Company REFS
Of course, this group can be refined further by market cap and so on. Then, canny investors could do worse than take a look at some of those companies not yet in play to assess the prospects of them being snapped up in the not too distant future.
Equity Release Returns
Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets. ROE is considered a gauge of a corporation’s profitability and how efficient it is in generating profits.