Investors expect good returns. The more cash you get back for the amount you invested, the better your investment is. 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 do not 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 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 return on invested capital might be declining. In other words, for every dollar of income generated, the company has to plough in 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, the fact is that these companies have sunk a lot of cash into investments by raising debt and by raising equity. Therefore, it makes more economic sense to find out whether these investments are generating returns that investors expect. Today, we will see how National Oilwell Varco (NYS: NOV) 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 here is for a 12-month period, ending June 30 of the corresponding year.
Invested capital has shown a steady growth in the past five years while returns have been fluctuating. However, the last 24 months have shown a steady decline in returns. Additionally, National Oilwell Varco's finished goods inventory was the fastest-growing segment, up 13.1% in the last 12 months. This is quite worrying.
In terms of competition, this is how National Oilwell Varco stacks up:
Return on Invested Capital (TTM)
Return on Equity (TTM)
National Oilwell Varco
Source: S&P Capital IQ. ROIC is author's calculation. TTM = trailing 12 months.
Compared to its peers, National Oilwell Varco's returns don't look too impressive.
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 tells us exactly that since both debt and equity are used for financing operations. Debt-to-equity currently stands at 3%.
National's after-tax interest expense, or cost of debt, stands at $29 million for the trailing-12-month period, which is nearly 6% 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 11.8%, which is higher than the ROIC of 6.9%. This is a potential red flag. National Oilwell Varco hasn't been able to build on shareholder value. The company has been investing in projects whose current returns are below 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. Nevertheless, I must add that National Oilwell Varco has huge potential going forward as oil services companies are in big demand. Still, investors can avoid possible pitfalls by finding out whether the company is capable of growing economically.
Add National Oilwell Varco to My Watchlist.
At the time thisarticle was published Fool contributor Isac Simon does not own shares of any of the companies mentioned in this article. The Motley Fool owns shares of CGG and National Oilwell Varco. Motley Fool newsletter services have recommended buying shares of National Oilwell Varco. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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