Is Industrial Alliance Insurance and Financial Services Inc's (TSE:IAG) 10.5% ROE Strong Compared To Its Industry?

The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about Return on Equity using a real-life example.

Industrial Alliance Insurance and Financial Services Inc (TSE:IAG) performed in-line with its life and health insurance industry on the basis of its ROE – producing a return of10.5% relative to the peer average of 9.2% over the past 12 months. But what is more interesting is whether IAG can sustain this level of return. A measure of sustainable returns is IAG’s financial leverage. If IAG borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface.

Check out our latest analysis for Industrial Alliance Insurance and Financial Services

What you must know about ROE

Return on Equity (ROE) weighs Industrial Alliance Insurance and Financial Services’s profit against the level of its shareholders’ equity. An ROE of 10.5% implies CA$0.10 returned on every CA$1 invested, so the higher the return, the better. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Life and Health Insurance sector by choosing the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.

ROE is measured against cost of equity in order to determine the efficiency of Industrial Alliance Insurance and Financial Services’s equity capital deployed. Its cost of equity is 8.6%. Since Industrial Alliance Insurance and Financial Services’s return covers its cost in excess of 1.9%, its use of equity capital is efficient and likely to be sustainable. Simply put, Industrial Alliance Insurance and Financial Services pays less for its capital than what it generates 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:

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Industrial Alliance Insurance and Financial Services’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at Industrial Alliance Insurance and Financial Services’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a sensible 39.6%, meaning Industrial Alliance Insurance and Financial Services has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.

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. Industrial Alliance Insurance and Financial Services’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For Industrial Alliance Insurance and Financial Services, I've compiled three relevant factors you should further examine:

1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Valuation: What is Industrial Alliance Insurance and Financial Services worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Industrial Alliance Insurance and Financial Services is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Industrial Alliance Insurance and Financial Services? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article 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.