If you're looking for a multi-bagger, there's a few things to keep an eye out for. One common approach is to try and find a company with returns on capital employed (ROCE) that are increasing, in conjunction with a growing amount of capital employed. This shows us that it's a compounding machine, able to continually reinvest its earnings back into the business and generate higher returns. Speaking of which, we noticed some great changes in Gulf Keystone Petroleum's (LON:GKP) returns on capital, so let's have a look.
Return On Capital Employed (ROCE): What is it?
If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. Analysts use this formula to calculate it for Gulf Keystone Petroleum:
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)
0.11 = US$65m ÷ (US$715m - US$107m) (Based on the trailing twelve months to June 2021).
Thus, Gulf Keystone Petroleum has an ROCE of 11%. On its own, that's a standard return, however it's much better than the 3.6% generated by the Oil and Gas industry.
In the above chart we have measured Gulf Keystone Petroleum's prior ROCE against its prior performance, but the future is arguably more important. If you'd like, you can check out the forecasts from the analysts covering Gulf Keystone Petroleum here for free.
What The Trend Of ROCE Can Tell Us
We're delighted to see that Gulf Keystone Petroleum is reaping rewards from its investments and has now broken into profitability. The company was generating losses five years ago, but has managed to turn it around and as we saw earlier is now earning 11%, which is always encouraging. Interestingly, the capital employed by the business has remained relatively flat, so these higher returns are either from prior investments paying off or increased efficiencies. So while we're happy that the business is more efficient, just keep in mind that could mean that going forward the business is lacking areas to invest internally for growth. Because in the end, a business can only get so efficient.
On a related note, the company's ratio of current liabilities to total assets has decreased to 15%, which basically reduces it's funding from the likes of short-term creditors or suppliers. So shareholders would be pleased that the growth in returns has mostly come from underlying business performance.
To bring it all together, Gulf Keystone Petroleum has done well to increase the returns it's generating from its capital employed. Since the stock has returned a staggering 114% to shareholders over the last five years, it looks like investors are recognizing these changes. Therefore, we think it would be worth your time to check if these trends are going to continue.
One more thing to note, we've identified 2 warning signs with Gulf Keystone Petroleum and understanding them should be part of your investment process.
For those who like to invest in solid companies, check out this free list of companies with solid balance sheets and high returns on equity.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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