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 Vodafone (VOD -0.42%) (VOD -0.24%), to see how attractive it looks on these two measures.
Vodafone's returns
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 profits by its equity (i.e., the difference between its total assets and its total liabilities) and is expressed as a percentage.
Vodafone has outperformed the FTSE 100 over the last five years, delivering an average dividend yield of 5.5% and a share price gain of 26% -- so how has Vodafone's ROE changed during that time?
|
2009 |
2010 |
2011 |
2012 |
2013 |
Average | |
|---|---|---|---|---|---|---|
|
ROE |
3.7% |
9.8% |
9.0% |
8.5% |
0.6% |
6.3% |
Revenue from Vodafone's Southern Europe operations fell by 16.7% last year, prompting a 7.7 billion pounds writedown on the value of its Italian and Spanish operations, and crushing its ROE.
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 Vodafone's net gearing and ROE alongside those of one of its European peers, Telefonica:
|
Company |
Net Gearing |
5-Year Average ROE |
|---|---|---|
|
Vodafone |
39.8% |
6.3% |
|
Telefonica |
259% |
33.3% |
Vodafone's ROE may be lower than investors would like, but one look at Telefonica's debt levels suggests to me that the British company may be a safer investment.
Is Vodafone a buy?
In its most recent results, Vodafone said that it's committed to maintaining the current dividend -- in other words, any increases are unlikely in the near future. Given the pressure on the firm's cash flow from dividends, falling profits in Southern Europe, and capital investment, this isn't surprising.
The sale of Vodafone's 45% stake in Verizon Wireless might address the firm's cash flow squeeze, but it is not yet certain how or if this will happen.
I think that the next few years may be a transitional period for Vodafone and rate it as a hold, despite the appeal of its 5.4% dividend yield.
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