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 income favorite National Grid , 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 (i.e., the difference between its total assets and its total liabilities) and is expressed as a percentage.
National Grid's dividend has risen by 38% since 2008, and its share price has risen by 23% over the last two years, compared to a 6.5% increase for the FTSE 100. This strong growth been reflected in National Grid's ROE, as this table shows:
National Grid recently agreed a new eight-year set of price controls for its U.K.-regulated operations. Since almost 66% of National Grid's profits come from the U.K. last year, the new price controls provide a high level of earnings visibility over the next eight years and have enabled the firm to commit to raising its dividend in line with RPI inflation for the foreseeable future.
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 National Grid's net gearing and ROE alongside those of two peers,SSE and Centrica.
National Grid's superior ROE appears to have come at a price, as its net gearing is more than twice that of SSE. However, as virtually all of National Grid's operations are regulated, I don't think this is too much of a risk.
Buy National Grid
National Grid's share price spiked up to 849 pence recently, before falling back even more quickly to its current level of around 740 pence. At this price, I think that the share's inflation-linked prospective yield of 5.8% is too good to ignore, making it a strong buy for income.
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The article What These Ratios Tell Us About National Grid originally appeared on Fool.com.
Roland Head owns shares in SSE but does not own shares in any of the other companies mentioned in this article. The Motley Fool recommends National Grid plc (ADR). 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.
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