What Do These Ratios Tell Us About British American Tobacco?

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 cigarette giant British American Tobacco (LSE: BATS  ) (NYSEMKT: BTI  )  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.

BAT's share price has risen by an impressive 89% since 2008, and its dividend payout has increase by 61%, so shareholders have been well rewarded.

Let's take a look at BAT's ROE for the last five years:

British American Tobacco

2008

2009

2010

2011

2012

Average

ROE

35.6%

37.3%

34.2%

35.6%

49.1%

38.4%

BAT's brand-led pricing power and emerging market growth have enabled it to deliver substantial ROE over the last five years, during which it has gained a loyal following from U.K. income investors.

A ruthless focus on profitability has helped drive up margins, and BAT's operating margin hit 35.6% last year.

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 listed BAT's net gearing and ROE alongside those of its U.K. peer, Imperial Tobacco. The difference is remarkable:

Company

Net Gearing

5-Year
Average ROE

Imperial Tobacco

178.5%

15.7%

British American Tobacco

115.3%

38.4%

BAT's higher returns and lower debt make a strong case for the firm, and Imperial's performance looks pretty unappetizing in comparison. It's no surprise that Imperial's share price has lagged behind that of BAT in recent years.

Is BAT a buy?
BAT's share price has fallen back by 7.5% since the FTSE 100 peaked in May, placing BAT shares on a forward P/E of 15.2, with a prospective yield of 4.3%.

Although this isn't cheap, I think that BAT shares still have more to offer and rate them a buy.

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