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

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Direct Line Insurance Group (LON:DLG) has had a rough month with its share price down 8.3%. However, stock prices are usually driven by a company’s financial performance over the long term, which in this case looks quite promising. Particularly, we will be paying attention to Direct Line Insurance Group's ROE today.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for Direct Line Insurance Group

How Do You Calculate Return On Equity?

The formula for ROE 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:

13% = UK£378m ÷ UK£3.0b (Based on the trailing twelve months to June 2021).

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. 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 13% ROE

To begin with, Direct Line Insurance Group seems to have a respectable ROE. Further, the company's ROE is similar to the industry average of 13%. 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. We reckon that there could be some other factors at play here that's limiting the company's growth. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.

Given that the industry shrunk its earnings at a rate of 2.8% in the same period, the net income growth of the company is quite impressive.

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. This then helps them determine if the stock is placed for a bright or bleak future. One good indicator of expected earnings growth is the P/E ratio which determines the price the market is willing to pay for a stock based on its earnings prospects. So, you may want to check if Direct Line Insurance Group is trading on a high P/E or a low P/E, relative to its industry.

Is Direct Line Insurance Group Efficiently Re-investing 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.

In addition, Direct Line Insurance Group has been paying dividends over a period of nine years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Looking at the current analyst consensus data, we can see that the company's future payout ratio is expected to rise to 85% 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

In total, we are pretty happy with Direct Line Insurance Group's performance. 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. 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 latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

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.

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