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 will see how Diamond Offshore (NYS: DO) 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.
ROIC has shown a steady decline in the past three years. However, I don't think it's anything to worry about. At 16.1%, the returns are still impressive. Oil drillers are back in business after a year's hiatus, following the Gulf of Mexico disaster, and things should further look up going forward.
In terms of competition, this is how Diamond stacks up.
SeaDrill (NYS: SDRL)
Weatherford International (NYS: WFT)
Noble (NYS: NE)
Source: S&P Capital IQ; ROIC is author's calculation; TTM = trailing 12 months.
Compared with its peers, Diamond's returns look the best among its peers.
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 35.1%.
Diamond's after-tax interest expense or cost of debt stands at $53 million for the trailing-12-month period, which is around 3.5% 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 9.8%. This is lower than the ROIC of 16.1%, which is what I'm looking for. Diamond Offshore has been able to build on shareholder value. The company has been investing in projects that generate returns that are above 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.
Add Diamond Offshore to My Watchlist.
At the time thisarticle was published Fool contributor Isac Simon owns no shares of any of the companies mentioned in this article.The Motley Fool owns shares of Noble. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.