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 and gas producer BG Group (LSE: BG) (NASDAQOTH: BRGYY.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.
BG Group’s return on equity has fallen in recent years, along with its share price. BG shares are worth just 9.5% more than they were five years ago, although the firm’s dividend has risen by 50% over that period:
| BG | 2008 | 2009 | 2010 | 2011 | 2012 | Average |
|---|---|---|---|---|---|---|
| ROE | 35.1% | 16.1% | 13.7% | 15.2% | 10.5% | 18.1% |
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 BG’s net gearing and ROE alongside those two of its peers, BP and Tullow Oil.
| Company | Net gearing | 5-year average ROE |
|---|---|---|
| Tullow Oil | 29.6% | 11.3% |
| BP | 13.8% | 14.3% |
| BG Group | 35.0% | 18.1% |
BG’s leadership in gas and LPG has helped it grow strongly, but revenue and profit growth has stalled over the last two years, as the firm’s biggest projects have sapped cash and taken longer to reach production readiness.
Is BG a buy?
Despite its £40bn market cap, BG Group currently trades on a P/E of around 19 times last year’s earnings. Although analysts expect the firm’s earnings to rise this year, I think that this valuation is too high for a company of this size; Royal Dutch Shell and BP currently trade on less than nine times earnings, and offer yields of more than 5%.
Over the medium term, I am confident that BG will deliver growth, but its high valuation, 1.5% yield and stretched cash flow doesn’t appeal to me. I believe that BG is still in the process of going ex-growth, so rate the shares as no more than a hold.
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> Roland owns shares in Royal Dutch Shell and BP but does not own shares in any of the other companies mentioned in this article.
