What Do These Ratios Tell Us About Diageo?

LONDON -- Before I decide whether to buy a company's shares, I always like to look at two core financial ratios -- return on equity and net gearing.

These two ratios provide an indication of how successful a company is at generating profits using shareholders' funds and debt, and they have a strong influence on dividend payments and share-price growth.

Today, I'm going to take a look at global drinks firm Diageo  (LSE: DGE  ) (NYSE: DEO  ) , to see how attractive it looks on these two measures.

Return on equity
The return a company generates on its shareholders' funds is known as return on equity, or ROE. ROE can be calculated by dividing a company's annual earnings by its equity (i.e., the difference between its total assets and its total liabilities) and is expressed as a percentage.

Over the last five years, Diageo's share price has doubled, and its dividend has risen by 26%. Let's take a look at Diageo's ROE for this period:

Diageo

2008

2009

2010

2011

2012

Average

ROE

40%

48.3%

45.9%

41.1%

36.1%

42.3%

Diageo's ROE is highly impressive, but these figures are so high that my first suspicion is that Diageo must be using a lot of debt to pump up returns -- is this true?

What about debt?
One weakness of ROE is that it doesn't show how much debt a company is using to boost its returns. A good way of assessing a company's debt levels is by looking at its net gearing -- the ratio of net debt to equity.

In the table below, I've compared net gearing and ROE for Diageo and two of its peers,SABMiller and Beam. The differences may surprise you:

Company

Net Gearing

5-year
Average ROE

Beam

47%

5%

SABMiller

60%

13%

Diageo

124%

42.3%

Diageo's net gearing is twice that of SABMiller, but the firm's five-year average ROE is 3.25 times that of SABMiller.

However, although Diageo's earnings per share have risen by an impressive average of 9.3% each year over the last five years, SABMiller has achieved a five-year average rate of 8.7% with half the gearing. Given Diageo CEO Paul Walsh's imminent departure, I'm concerned that Diageo's growth may be about to slow.

Is Diageo a buy?
Diageo is currently quite richly priced, with a P/E of 19 and a dividend yield of just 2.3%.

For existing investors, it may be a hold, but for new buyers, I'm not sure that now is a good time to buy. Personally, I plan to wait until Diageo looks a little cheaper or offers a more attractive yield.

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