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What Do These Ratios Tell Us About British American Tobacco PLC (ADR) (BTI)?

British American Tobacco PLCLONDON — 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 cigarette giant British American Tobacco PLC (ADR) (NYSEMKT:BTI) 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. ROE can be calculated by dividing a company’s annual earnings by its equity (i.e., the difference between its total assets and its total liabilities) and is expressed as a percentage.

British American Tobacco PLC (ADR) (NYSEMKT:BTI) share price has risen by an impressive 89% since 2008, and its dividend payout has increase by 61%, so shareholders have been well rewarded.

Let’s take a look at British American Tobacco PLC (ADR) (NYSEMKT:BTI)’s ROE for the last five years:

British American Tobacco 2008 2009 2010 2011 2012 Average
ROE 35.6% 37.3% 34.2% 35.6% 49.1% 38.4%

British American Tobacco PLC (ADR) (NYSEMKT:BTI)’s brand-led pricing power and emerging market growth have enabled it to deliver substantial ROE over the last five years, during which it has gained a loyal following from U.K. income investors.

A ruthless focus on profitability has helped drive up margins, and British American Tobacco PLC (ADR) (NYSEMKT:BTI)’s operating margin hit 35.6% last year.

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 British American Tobacco PLC (ADR) (NYSEMKT:BTI)’s net gearing and ROE alongside those of its U.K. peer, Imperial Tobacco. The difference is remarkable:

Company Net Gearing 5-Year
Average ROE
Imperial Tobacco 178.5% 15.7%
British American Tobacco PLC (ADR) (NYSEMKT:BTI) 115.3% 38.4%

British American Tobacco PLC (ADR) (NYSEMKT:BTI)’s higher returns and lower debt make a strong case for the firm, and Imperial’s performance looks pretty unappetizing in comparison. It’s no surprise that Imperial’s share price has lagged behind that of BAT in recent years.

Is BAT a buy?
BAT’s share price has fallen back by 7.5% since the FTSE 100 peaked in May, placing British American Tobacco PLC (ADR) (NYSEMKT:BTI) shares on a forward P/E of 15.2, with a prospective yield of 4.3%.

Although this isn’t cheap, I think that BAT shares still have more to offer and rate them a buy.

The article What Do These Ratios Tell Us About British American Tobacco? originally appeared on Fool.com.

Roland Head does not own shares of any of the companies mentioned in this article, and neither does The Motley Fool.

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