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. 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 Unilever's ROE over the last five years:
Unilever's five-year average ROE of 33.5% is impressive, but to see how competitive it really is, we need to compare it to some of its peers, 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 Unilever's net gearing and ROE alongside those of its main U.K. rival, Reckitt Benckiser:
Unilever's products are mostly staple goods that we will always buy, regardless of economic conditions. This provides Unilever with pricing power, which is also helped by customers' loyalty to the firm's brands.
I think that Reckitt's growth may be harder to sustain, as it is dependent on high margins and a move into health care, which could expose it to tough new competition.
Unilever's focus on food and personal hygiene products, and its strong emerging market growth, look much more attractive to me.
Is Unilever a buy?
Trading on a P/E of 20, Unilever's shares are not cheap at the moment, but they do provide access to a high-quality income stream.
This year's rising market has pushed Unilever's dividend yield down to the FTSE 100 average, and at the firm's current share price, I'd hold. However, if the market's recent losses continue, and Unilever's shares drop below 2,500 pence, I'd rate them a buy.
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Roland Head owns shares of Unilever. The Motley Fool recommends Reckitt Benckiser Group and Unilever. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.
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