Canada Markets open in 4 hrs 24 mins

Declining Stock and Solid Fundamentals: Is The Market Wrong About Direct Line Insurance Group plc (LON:DLG)?

With its stock down 17% over the past three months, it is easy to disregard Direct Line Insurance Group (LON:DLG). However, a closer look at its sound financials might cause you to think again. Given that fundamentals usually drive long-term market outcomes, the company is worth looking at. In this article, we decided to focus on Direct Line Insurance Group's ROE.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. Put another way, it reveals the company's success at turning shareholder investments into profits.

View our latest analysis for Direct Line Insurance Group

How To Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Direct Line Insurance Group is:

12% = UK£344m ÷ UK£2.9b (Based on the trailing twelve months to December 2021).

The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.12 in profit.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

A Side By Side comparison of Direct Line Insurance Group's Earnings Growth And 12% ROE

To begin with, Direct Line Insurance Group seems to have a respectable ROE. And on comparing with the industry, we found that the the average industry ROE is similar at 12%. However, we are curious as to how Direct Line Insurance Group's decent returns still resulted in flat growth for Direct Line Insurance Group in the past five years. So, there could be some other aspects that could potentially be preventing the company from growing. Such as, the company pays out a huge portion of its earnings as dividends, or is faced with competitive pressures.

Next, on comparing with the industry net income growth, we found that the growth figure reported by Direct Line Insurance Group compares quite favourably to the industry average, which shows a decline of 6.1% in the same period.

past-earnings-growth
past-earnings-growth

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. Doing so will help them establish if the stock's future looks promising or ominous. If you're wondering about Direct Line Insurance Group's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is Direct Line Insurance Group Making Efficient Use Of Its Profits?

The high three-year median payout ratio of 65% (meaning, the company retains only 35% of profits) for Direct Line Insurance Group suggests that the company's earnings growth was miniscule as a result of paying out a majority of its earnings.

Moreover, Direct Line Insurance Group has been paying dividends for nine years, which is a considerable amount of time, suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 82% over the next three years. However, Direct Line Insurance Group's future ROE is expected to rise to 17% despite the expected increase in the company's payout ratio. We infer that there could be other factors that could be driving the anticipated growth in the company's ROE.

Conclusion

On the whole, we feel that Direct Line Insurance Group's performance has been quite good. We are particularly impressed by the considerable earnings growth posted by the company, which was likely backed by its high ROE. While the company is paying out most of its earnings as dividends, it has been able to grow its earnings in spite of it, so that's probably a good sign. With that said, the latest industry analyst forecasts reveal that the company's earnings are expected to accelerate. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.