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 utility and energy producer Centrica (CNA 1.38%) (CPYYY 1.79%), 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. Return on equity can be calculated by dividing a company's annual earnings by its equity (ie, the difference between its total assets and its total liabilities) and is expressed as a percentage.
Centrica's business requires a lot of capital investment, which can result in quite uneven returns. To smooth out these variations, I've included the firm's average return on equity for the last five years:
|
Centrica |
2008 |
2009 |
2010 |
2011 |
2012 |
Average |
|---|---|---|---|---|---|---|
|
ROE |
1.2% |
15% |
37.4% |
7.7% |
22.1% |
16.7% |
Centrica's average ROE of 16.7% is quite attractive, but to see how competitive it really is, we need to compare it to some similar companies, which I'll do in a moment.
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 Centrica's net gearing and ROE alongside those of its peers. I've included both oil companies and utilities, because Centrica's earnings are divided roughly equally between these two sectors:
|
Company |
Net gearing |
5-year average ROE |
|---|---|---|
|
Royal Dutch Shell |
10.1% |
15.8% |
|
Centrica |
74.1% |
16.7% |
|
SSE |
100.5% |
23.1% |
|
National Grid |
215% |
26.4% |
Centrica's ROE and net gearing looks pretty reasonable to me, suggesting that the firm's management are doing quite a good job.
These figures highlight how debt can be used to increase ROE, but 100%-plus levels of net gearing are much less risky for utilities than for other companies, thanks to their guaranteed, regulated incomes.
Is Centrica a buy?
Centrica's current P/E of 14 and its dividend yield of 4.4% both seem reasonably good value to me, given its moderate debt levels, and strong record of generating a competitive return on equity.
Although I don't think Centrica is a bargain at today's price of 375 pence, I do think that it looks fairly valued, considering the company's potential for delivering sustainable, long-term returns.
Finding market-beating returns
If you already own shares in Centrica, then I'd strongly recommend that you take a look at this special Motley Fool report. Newly updated for 2013, it contains details of top U.K. fund manager Neil Woodford's eight largest holdings.
Mr. Woodford's track record is impressive: if you'd invested £10,000 into his High Income fund in 1988, it would have been worth £193,000 at the end of 2012 -- a 1,830% increase!
This special report is completely free, but availability is limited, so click here to download your copy immediately.
