ICC Holdings Inc (NASDAQ:ICCH) delivered a less impressive 5.23% ROE over the past year, compared to the 8.79% return generated by its industry. Though ICCH’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 ICCH’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of ICCH’s returns. Let me show you what I mean by this. Check out our latest analysis for ICC Holdings
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs ICCH’s profit against the level of its shareholders’ equity. An ROE of 5.23% implies $0.05 returned on every $1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Property and Casualty Insurance sector by investing in the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for ICCH, which is 9.60%. This means ICCH’s returns actually do not cover its own cost of equity, with a discrepancy of -4.37%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue ICCH can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable ICCH’s capital structure is. We can determine if ICCH’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at ICCH’s debt-to-equity ratio. The most recent ratio is 7.79%, which is sensible and indicates ICCH has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and ICCH still has room to increase leverage and grow future returns.
ROE – It’s not just another ratio
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. ICCH’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. There are other important measures we need to consider in order to conclude on the quality of its returns. I recommend you see our latest FREE analysis report to find out more about these measures!
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