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.
Supermarket J Sainsbury (LSE: SBRY) (NASDAQOTH: JSAIY.US) has a 16.8% share of the UK market, but how attractive does 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.
Supermarket retailing is a competitive and low margin business, and Sainsbury’s return on equity appears quite low compared to some other industries:
Despite these relatively modest numbers, Sainsbury’s consistency and gradual growth has seen its share price rise by 25%, and its dividend rise by 26% over the last five years, so how does it compare to its peers?
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 Sainsbury’s net gearing and ROE alongside those of its peers, Tesco and Morrisons.
Sainsbury’s lower returns may be explained by its margins, which have historically been lower than those of Tesco and Morrisons.
Despite this, Sainsbury has delivered 34 consecutive quarters of like-for-like sales growth, its UK market share expanded last year, and its prospective yield of 4.6% is the highest of the three, by a small margin.
Is Sainsbury a buy?
Looking ahead, all three supermarkets are facing tight market conditions, but are continuing to spend heavily on opening new convenience stores, which are currently the main driver of sales growth.
Sainsbury has outperformed its peers in store and in terms of share price performance over the last five years, but it now seems quite fully priced to me, so I rate Sainsbury as a hold.
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> Roland owns shares in Tesco but does not own shares in any of the other companies mentioned in this article. The Motley Fool owns shares in Tesco.