LONDON -- 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 utility and energy producer Centrica , 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 earnings by its equity (ie, the difference between its total assets and its total liabilities) and is expressed as a percentage.
Centrica's business requires a lot of capital investment, which can result in quite uneven returns. To smooth out these variations, I've included the firm's average return on equity for the last five years:
Centrica's average ROE of 16.7% is quite attractive, but to see how competitive it really is, we need to compare it to some similar companies, which I'll do in a moment.
What about debt?
One weakness of ROE is that it doesn't show how much debt a company is using to boost its returns. A good way of assessing a company's debt levels is by looking at its net gearing -- the ratio of net debt to equity.
In the table below, I've listed Centrica's net gearing and ROE alongside those of its peers. I've included both oil companies and utilities, because Centrica's earnings are divided roughly equally between these two sectors:
5-year average ROE
Royal Dutch Shell
Centrica's ROE and net gearing looks pretty reasonable to me, suggesting that the firm's management are doing quite a good job.
These figures highlight how debt can be used to increase ROE, but 100%-plus levels of net gearing are much less risky for utilities than for other companies, thanks to their guaranteed, regulated incomes.
Is Centrica a buy?
Centrica's current P/E of 14 and its dividend yield of 4.4% both seem reasonably good value to me, given its moderate debt levels, and strong record of generating a competitive return on equity.
Although I don't think Centrica is a bargain at today's price of 375 pence, I do think that it looks fairly valued, considering the company's potential for delivering sustainable, long-term returns.
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The article What Do These Ratios Tell Us About Centrica? originally appeared on Fool.com.
Roland Headowns shares in Royal Dutch Shell and SSE, but does not own shares in any of the other companies mentioned in this article. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.