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 defence firm BAE Systems (LSE: BA) (NASDAQOTH: BAESY.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.
BAE’s share price has risen by 44% over the last year and its dividend payout is up by 35% since 2008. Has the firm’s return on equity risen, too?
| BAE Systems | 2008 | 2009 | 2010 | 2011 | 2012 | Average |
|---|---|---|---|---|---|---|
| ROE | 26.4% | -1.4% | 19.4% | 26.0% | 28.7% | 19.8% |
BAE’s ROE has returned to pre-recession levels, as its profits have remained strong, despite defence spending cuts in the UK and US, its two main markets.
What about debt? Â
One 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.
BAE’s ability to generate cash enabled it to move to a small net cash position last year, so it certainly isn’t using debt to boost its returns. How does this compare to two of its UK defence peers, Meggitt and Cobham?
| Company | Net gearing | 5-year average ROE |
|---|---|---|
| Meggitt | 33.7% | 10.8% |
| Cobham | 34.2% | 16.3% |
| BAE Systems | -9.9% | 19.8% |
BAE’s high ROE and net cash place it ahead of Meggitt and Cobham, although the two smaller firms might be better positioned to deliver outright growth than BAE, whose market cap is twice that of the other two firms combined.
Is BAE Systems a buy?
BAE’s interim results are due on 1 August, and should provide an interesting update on progress so far this year. City analysts are forecasting earnings per share of 42.1p for 2013, which places BAE on a forward P/E of just 10.4.
However, UK and US government spending cuts suggest to me that BAE’s medium-term growth prospects are limited, so I think that the firm’s shares are already fairly priced and rate as a hold.
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> Roland owns shares in BAE Systems but not in any of the other companies mentioned in this article.