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 supermarket Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.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.
Tesco’s share price is unchanged from five years ago, but the firm’s dividend has risen by almost 25% since then, highlighting Tesco’s strength as an income stock. Let’s see how the supermarket’s ROE has changed over the same period:
| Tesco | 2009 | 2010 | 2011 | 2012 | 2013 | Average |
|---|---|---|---|---|---|---|
| ROE | 16.6% | 15.9% | 16.1% | 17.8% | 8.3% | 14.9% |
Tesco’s ROE has hovered around 16% historically, but it nose-dived last year, when its gross profits fell by 24%, and the firm was also forced to write-down its loss-making US business, and a big chunk of its UK property portfolio.
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 Tesco’s net gearing and ROE alongside those of its peers. J Sainsbury and Wm Morrison Supermarkets:
| Company | Net gearing | 5-year average ROE |
|---|---|---|
| Sainsbury | 39.5% | 10.5% |
| Morrison | 41.4% | 12.0% |
| Tesco | 46.9% | 14.9% |
Despite its current challenges, the figures above suggest that Tesco has delivered superior returns over the last five years to its main two UK-listed competitors. Although Tesco’s gearing is higher, the difference is relatively small, and all three have debt levels that should remain very manageable.
Is Tesco a buy?
Tesco’s share price has risen by 15% over the last year, narrowly underperforming the FTSE 100, which has risen by 18% since last July. It offers a 4.2% prospective yield and trades on 11.1 times this year’s forecast earnings.
In my view, this is a fair valuation for the medium term, but Tesco’s reliable, above-average income, and long-term growth prospects, mean that I rate the shares a buy.
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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 and has recommended Morrison.
