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.
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 (i.e., the difference between its total assets and its total liabilities) and is expressed as a percentage.
ARM's ROE has improved over the past five years, as these figures show:
ARM's return on equity has risen by 115% since 2008, thanks mainly to the smartphone boom, which has caused a surge in demand for its chip designs from customers including Apple and Samsung.
What about debt?
A key weakness of ROE is that it doesn't show how much debt a company is using to boost its returns. My preferred way of measuring a company's debt is by looking at its net gearing -- the ratio of net debt to equity.
Both ARM and its smaller U.K. peer Imagination Technologies have net cash on their balance sheet, which results in negative net gearing. Here's how the two companies compare:
Is ARM Holdings a buy?
ARM's net cash and rising ROE might attract me to the stock, if it wasn't for the firm's valuation. Although ARM's share price has fallen by 23% from its peak on May 15, it still trades on a forward price-to-earnings ratio (P/E) of 41.
ARM fans say that the firm's potential justifies its valuation, but I'm not sure. The company's rising profits in recent years have been driven by a massive rise in volumes, while the firm's profit margins per chip have actually fallen.
ARM's market capitalization of 11 billion pounds seems ambitious to me, considering that it only generated pre-tax profits of 221 million last year, which equates to a P/E of 72!
Early investors in ARM have done well, but I cannot see any reason for new buyers to invest in the firm's stock at the moment.
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Roland Head and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.