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 oil major BP (LSE: BP) (NYSE: BP.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.
BP’s Gulf of Mexico disaster has cost the company $42.4 billion so far. Despite this, it has managed to deliver a positive return on equity over the last two years:
| 2008 | 2009 | 2010 | 2011 | 2012 | Average | |
|---|---|---|---|---|---|---|
| ROE | 22.9% | 17.2% | -3.8% | 24.9% | 10.1% | 14.3% |
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.
How does BP compare to the two other European supermajors?
| Company | Net gearing | 5-year average ROE |
|---|---|---|
| BP | 13.8% | 14.3% |
| Royal Dutch Shell | 10.1% | 15.8% |
| Total SA | 28.4% | 18.4% |
On the face of it, Shell is a superior investment to BP, using less gearing to produce higher returns.
However, as yesterday’s results showed, Shell is struggling to maintain its shareholder returns and its ROE has fallen to 13.4% over the last twelve months, whereas BP’s ROE has risen to 20.4% over the same period.
Is BP a buy?
The three European supermajors all currently trade on very low valuations — less than 9 times forecast earnings with dividend yields in excess of 5%.
BP is the cheapest of the three by a small margin, but it’s also burdened with the biggest single risk: if it’s found guilty of gross negligence in Louisiana, BP could face fines of up to $22bn. If a lesser verdict is passed, then it may still face fines of $3-$5bn.
BP’s $20bn Macondo trust fund is almost exhausted, so these fines and other payouts will come directly out of the firm’s profits. For this reason, I think BP is fairly valued for now, and rates as a hold.
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> Roland owns shares in BP and Royal Dutch Shell, but not in Total.
