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 High Street stalwart Marks & Spencer Group (MKS 0.41%) (MAKSY 0.32%) 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.
Let's start with a look at Marks & Spencer's ROE for the last five years:
|
Marks & Spencer |
2009 |
2010 |
2011 |
2012 |
2013 |
Average |
|---|---|---|---|---|---|---|
|
ROE |
25.2% |
24.8% |
25.3% |
18.8% |
17.6% |
22.3% |
Marks & Spencer's five-year average ROE of 22.3% isn't bad in itself, but what is worrying is the downward trend over the last three years.
The firm's declining clothing sales have been dragging down its returns and placing pressure on its profits and cash flow, while its dividend has been unchanged for three years.
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 Marks & Spencer's net gearing and ROE with those of Debenhams and Sports Direct International, two of its High Street peers:
|
Company |
Net Gearing |
5-Year |
|---|---|---|
|
Marks & Spencer |
82.9% |
22.3% |
|
Sports Direct International |
29.1% |
25.3% |
|
Debenhams |
43.1% |
29.6% |
These figures highlight how M&S is delivering lower returns than its two peers, which have much lower gearing and higher returns on equity.
From a shareholder's perspective, this is reflected in the companies' share prices -- Sports Direct's share price has risen by 125% over the last two years, compared to 25% for Debenhams and just 16% for M&S.
Is Marks & Spencer a buy?
The first test of M&S's new clothing management team will come this autumn, when it launches its new collections.
Even if it's successful, any turnaround will take some time, and for that reason -- as well as M&S' whopping 550 million-pound pension deficit -- I rate Marks & Spencer as no more than a hold.
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