Return on Capital Employed - Some Thoughts - Your thoughts welcomed

ROCE comes up as a measure of business performance, particularly with sophisticated long only accounts. Below are some pro's / con's of this measure as an investment screen in E&P (as I see it).

1/n

Pro's
- EBIT is pretty close to earnings and also approximates 'sustainable' Free Cash Flow. In the 'less adjustments the better' school of thought this is pretty good.
- The return framework does give you a sense on the IRR of your investment
- It's driven by audited numbers

2n

Con's
- #1 is it's not very comparable. If a E&P bought land cheap 20 years ago and prudently developed it, its ROCE will look great (low book value). If an E&P acquired land later for a higher value (higher book value) it's ROCE will look low.

3/n

But if you Price/Book adjust the ROCE, the return expectation could be the same.

Case study: COG's TTM ROCE is 8%. EV/Assets is 1.8x; so you could argue its adjusted to 4.4%. Many E&P's trade at an EV/Asset of <1x. So you could be more interested in a lower ROCE offering.

4/n

- #2 Acquisitions muck up the book value; so do owned vs unowned infrastructure

-#3 what about inventory? a 10% ROCE business that is going to run out of locations in 5 years is more desirable than a 7% ROCE business that has 20 years of inventory?

5/n

-#4 watch out for impairments. A large impairment will make 1 year of ROCE look bad -- unless you adjust it out -- but every year after will look great --> the big bath effect!

6/n

-#5 depreciation /= sustaining capital. Given current YoY cost efficiencies it is too punitive a deduction. If forecasting DD&A it can be a bit of a guessing game.

Net/net lots of pitfalls (my view). Might not be the best measure suited to investment selection in E&P. Thoughts?