Direct Line Insurance Group's (LON:DLG) stock is up by a considerable 11% over the past three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. In this article, we decided to focus on Direct Line Insurance Group's ROE.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Put another way, it reveals the company's success at turning shareholder investments into profits.
How Is ROE Calculated?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Direct Line Insurance Group is:
13% = UK£401m ÷ UK£3.1b (Based on the trailing twelve months to June 2020).
The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.13 in profit.
Why Is ROE Important For Earnings Growth?
So far, we've learned that ROE is a measure of a company's profitability. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.
Direct Line Insurance Group's Earnings Growth And 13% ROE
To start with, Direct Line Insurance Group's ROE looks acceptable. Even when compared to the industry average of 13% the company's ROE looks quite decent. Despite the moderate return on equity, Direct Line Insurance Group has posted a net income growth of 2.5% over the past five years. A few likely reasons that could be keeping earnings growth low are - the company has a high payout ratio or the business has allocated capital poorly, for instance.
We then compared Direct Line Insurance Group's net income growth with the industry and found that the company's growth figure is lower than the average industry growth rate of 11% in the same period, which is a bit concerning.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Is DLG fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Direct Line Insurance Group Using Its Retained Earnings Effectively?
With a high three-year median payout ratio of 65% (or a retention ratio of 35%), most of Direct Line Insurance Group's profits are being paid to shareholders. This definitely contributes to the low earnings growth seen by the company.
Moreover, Direct Line Insurance Group has been paying dividends for eight years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Upon studying the latest analysts' consensus data, we found that the company is expected to keep paying out approximately 77% of its profits over the next three years. However, Direct Line Insurance Group's ROE is predicted to rise to 20% despite there being no anticipated change in its payout ratio.
On the whole, we do feel that Direct Line Insurance Group has some positive attributes. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE. Bear in mind, the company reinvests a small portion of its profits, which means that investors aren't reaping the benefits of the high rate of return. That being so, the latest analyst forecasts show that the company will continue to see an expansion in its earnings. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.
This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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