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 pharmaceutical firm AstraZeneca (LSE: AZN) (NYSE: AZN.US), 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 profit by its equity (ie, the difference between its total assets and its total liabilities) and is expressed as a percentage.
AstraZeneca’s share price has risen by 43% over the last five years, while its dividend has risen by 36%. However, the firm’s return on equity weakened last year, as its profits fell sharply:
| AstraZeneca | 2008 | 2009 | 2010 | 2011 | 2012 | Average |
|---|---|---|---|---|---|---|
| ROE | 39.8% | 41.1% | 36.7% | 43.0% | 26.8% | 37.5% |
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.
In the table below, I’ve listed Astra’s net gearing and ROE alongside those of its UK peers, Shire and GlaxoSmithKline:
| Company | Net gearing | 5-year average ROE |
|---|---|---|
| Shire | -9.3% (net cash) |
24.7% |
| AstraZeneca | 9.8% | 37.5% |
| GlaxoSmithKline | 230.1% | 51.9% |
Astra’s five-year average ROE looks impressive when set alongside its low gearing levels, which are a sharp contrast to Glaxo’s net debt of £15.4bn.
Is Astra a buy?
The only problem with Astra’s impressive past performance is that it isn’t going to be repeated — at least not for a few years.
City analysts expect Astra’s earnings to fall over the next couple of years, as it loses patent protection on several key products. At the same time, the firm will continue to spend on acquisitions to backfill its pipeline of new drugs.
For income seekers, Astra’s 5.7% dividend yield means that the firm must remain a contender. However, while the firm currently trades on a relatively low forward P/E of around 10, with earnings forecast to fall, the share price may follow, at least in the short term.
Overall, I rate Astra as a hold — long-term holders should do well, as should income seekers, but the firm’s sticky patch isn’t over yet.
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> Roland owns shares in GlaxoSmithKline but does not own shares in any of the other companies mentioned in this article. The Motley Fool has recommended Shire.
