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 petroleum and mining giant BHP Billiton (LSE: BLT) (NYSE: BBL.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.
BHP Billiton avoided the full-year losses posted by peers Rio Tinto and Anglo American last year, mainly because of its profitable petroleum business.
The firm’s share price is almost unchanged on five years ago, but its dividend has risen by more than 60% over that time, so has BHP’s ROE reflected this growth?
| BHP Billiton | 2008 | 2009 | 2010 | 2011 | 2012 | Average |
|---|---|---|---|---|---|---|
| ROE | 40.1% | 14.7% | 26.2% | 41.7% | 23.4% | 29.2% |
BHP Billiton’s return on equity appears to be pretty solid. Year-on-year fluctuations are to be expected in a business where commodity prices vary, and capital expenditure is large and unevenly spaced, but the firm’s record looks good at first glance.
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 BHP’s net gearing and ROE alongside those of Rio Tinto and BP. BHP’s earnings are derived from both mining and petroleum production, so how does it compare to these two firms?
| Company | Net gearing | 5-year average ROE |
|---|---|---|
| BP | 13.8% | 13.8% |
| Rio Tinto | 41.0% | 14.3% |
| BHP Billiton | 45.1% | 29.2% |
BHP’s five-year average ROE is more than twice that of the other two firms, but while Rio’s net gearing is similar, BP’s lower gearing makes its lower returns look more acceptable.
BHP Billiton is a buy
BHP Billiton shares currently offer a prospective yield of around 4.5%, giving investors the chance to receive an above-average income derived from a basket of key natural resources — petroleum, iron ore, copper and aluminium.
I rate BHP Billiton as a strong buy at present, and would hold the shares for income, regardless of any further market volatility.
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> Roland owns shares in Rio Tinto and BP but does not own shares in any of the other companies mentioned in this article.
