NI Holdings Inc’s (NASDAQ:NODK) most recent return on equity was a substandard 6.11% relative to its industry performance of 9.39% over the past year. Though NODK’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on NODK’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of NODK’s returns. See our latest analysis for NI Holdings

Breaking down Return on Equity

Return on Equity (ROE) weighs NI Holdings’s profit against the level of its shareholders’ equity. An ROE of 6.11% implies $0.06 returned on every $1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is measured against cost of equity in order to determine the efficiency of NI Holdings’s equity capital deployed. Its cost of equity is 8.49%. Given a discrepancy of -2.39% between return and cost, this indicated that NI Holdings may be paying more for its capital than what it’s generating in return. ROE can be broken down into three different ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

Dupont Formula

ROE = profit margin × asset turnover × financial leverage

ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)

ROE = annual net profit ÷ shareholders’ equity

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue NI Holdings can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt NI Holdings currently has. Currently, NI Holdings has no debt which means its returns are driven purely by equity capital. This could explain why NI Holdings’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.

Next Steps:

While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. NI Holdings’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of NI Holdings’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.