Before I decide whether to buy a company’s shares, I always like to look at its return on equity.
This key ratio provide an indication of how successful a company is at generating profits using shareholders’ funds and can have a strong influence on dividend payments and share price growth.
Today, I’m going to take a look at Royal Bank of Scotland spin-off Direct Line Insurance Group (LSE: DLG), 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 (ie, the difference between its total assets and its total liabilities) and is expressed as a percentage.
Although it only floated in October, Direct Line’s trading results have been made available back to 2009, enabling us to see how its performance has changed over the last few years:
| Direct Line Group | 2009 | 2010 | 2011 | 2012 | 2013 YTD | Average |
|---|---|---|---|---|---|---|
| ROE | 8.0% | -8.3% | 7.3% | 5.7% | 8.9% | 4.4% |
How does Direct Line compare?
A recognised measure of an insurance company’s financial strength is its Insurance Groups Directive capital coverage ratio. This measures the amount of surplus capital held by an insurance company, in excess of its regulatory requirements.
In the table below, I’ve listed Direct Line’s IGD coverage ratio and ROE, alongside those of two of its UK peers in the car insurance sector, Aviva and RSA Insurance Group, which offers car insurance through its More Than brand.
| Company | IGD capital coverage ratio | 2009-13 average ROE |
|---|---|---|
| Aviva | 175% | 4.0% |
| Direct Line Group | 272% | 4.4% |
| RSA Insurance | 170% | 11.8% |
Direct Line appears to be very well funded, but its return on equity over the last five years has been relatively lacklustre — indeed, it reported an operating loss in both 2009 and 2010, leaving it only marginally ahead of Aviva on a five-year average basis.
Is Direct Line a buy?
Direct Line’s return on equity for the last twelve months has risen to 8.9%, compared with 5.7% in 2012. The company reported a 27.8% increase in first-half operating profits and a combined ratio of 94.6%, meaning that its operating costs and claim payouts are less than its income from insurance premiums.
The group currently trades on a 2013 forecast P/E ratio of just 10.3, and offers a generous prospective yield of 5.6%, suggesting to me that it is quite attractively priced at the moment.
Overall, I rate Direct Line as a strong potential buy for income investors.
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> Roland owns shares in Aviva does not own shares in any of the other companies mentioned in this article.
