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Insurance Australia Group Limited's (ASX:IAG) Stock Going Strong But Fundamentals Look Weak: What Implications Could This Have On The Stock?

Insurance Australia Group (ASX:IAG) has had a great run on the share market with its stock up by a significant 11% over the last three months. However, we decided to pay close attention to its weak financials as we are doubtful that the current momentum will keep up, given the scenario. Particularly, we will be paying attention to Insurance Australia Group's ROE today.

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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Insurance Australia 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 Insurance Australia Group is:

6.5% = AU$424m ÷ AU$6.5b (Based on the trailing twelve months to June 2022).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.07 in profit.

What Is The Relationship Between ROE And Earnings Growth?

Thus far, we have learned that ROE measures how efficiently a company is generating its profits. 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 all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

Insurance Australia Group's Earnings Growth And 6.5% ROE

At first glance, Insurance Australia Group's ROE doesn't look very promising. However, given that the company's ROE is similar to the average industry ROE of 6.5%, we may spare it some thought. But then again, Insurance Australia Group's five year net income shrunk at a rate of 42%. Bear in mind, the company does have a slightly low ROE. Hence, this goes some way in explaining the shrinking earnings.

That being said, we compared Insurance Australia Group's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 8.1% in the same period.

past-earnings-growth
past-earnings-growth

Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. Has the market priced in the future outlook for IAG? You can find out in our latest intrinsic value infographic research report.

Is Insurance Australia Group Using Its Retained Earnings Effectively?

With a high three-year median payout ratio of 79% (implying that 21% of the profits are retained), most of Insurance Australia Group's profits are being paid to shareholders, which explains the company's shrinking earnings. With only very little left to reinvest into the business, growth in earnings is far from likely.

In addition, Insurance Australia Group has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 79%. Still, forecasts suggest that Insurance Australia Group's future ROE will rise to 13% even though the the company's payout ratio is not expected to change by much.

Conclusion

On the whole, Insurance Australia Group's performance is quite a big let-down. The company has seen a lack of earnings growth as a result of retaining very little profits and whatever little it does retain, is being reinvested at a very low rate of return. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. 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.

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