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 one of the 'big three' London-listed miners, Rio Tinto (RIO 0.29%) (RIO 1.16%), 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.
Let's start with a look at Rio's ROE for the last five years:
|
Rio Tinto |
2008 |
2009 |
2010 |
2011 |
2012 |
Average |
|---|---|---|---|---|---|---|
|
ROE |
19.8% |
16.5% |
28.1% |
10.5% |
(6.0)% |
13.8% |
In January this year, Rio Tinto announced non-cash impairments totaling $14 billon, due to writedowns in the value of its aluminum business and its Mozambique coal assets, both of which the firm now admits it paid too much for.
This drop in the company's asset values -- combined with its first ever annual loss -- resulted in a negative ROE for 2012.
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 Rio Tinto's net gearing and ROE alongside those of its London-listed peers, Anglo American and BHP Billiton:
|
Company |
Net Gearing |
5-Year |
|---|---|---|
|
Rio Tinto |
41.0% |
13.8% |
|
Anglo American |
22.7% |
13.9% |
|
BHP Billiton |
45.1% |
31.8% |
These figures show what happen when investments go wrong -- Rio's net gearing doubled last year, thanks to last year's triple-whammy of falling earnings, high capital expenditure and asset writedowns.
In contrast, BHP Billiton has delivered far superior returns, thanks mostly to its petroleum division, which has offset a fall in mining profits.
Buy Rio Tinto
Rio has taken decisive measures to cut costs, and I think it will make a strong return to profit this year. Although last year's losses are a disappointment, it's worth remembering that its Pilbara mine remains one of the world's largest, most profitable iron ore mines. Rio's prospective yield of 4.2% is also attractive.
I recently topped up my own holding in Rio, and continue to believe the firm's shares are a buy.
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