Most readers would already know that Direct Line Insurance Group's (LON:DLG) stock increased by 7.3% over the past three months. We wonder if and what role the company's financials play in that price change as a company's long-term fundamentals usually dictate market outcomes. Specifically, we decided to study Direct Line Insurance Group's ROE in this article.

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.

View our latest analysis for Direct Line Insurance Group

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:

12% = UK£367m ÷ UK£3.0b (Based on the trailing twelve months to December 2020).

The 'return' is the profit over the last twelve months. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.12 in profit.

What Has ROE Got To Do With 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.

Direct Line Insurance Group's Earnings Growth And 12% ROE

At first glance, Direct Line Insurance Group seems to have a decent ROE. Even when compared to the industry average of 11% the company's ROE looks quite decent. Despite the moderate return on equity, Direct Line Insurance Group has posted a net income growth of 2.6% 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.

Next, on comparing with the industry net income growth, we found that Direct Line Insurance Group's reported growth was lower than the industry growth of 12% in the same period, which is not something we like to see.

Earnings growth is an important metric to consider when valuing a stock. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. Is DLG fairly valued? This infographic on the company's intrinsic value has everything you need to know.