This analysis is intended to introduce important early concepts to people who are starting to invest and looking to gauge the potential return on investment in EMC Insurance Group Inc (NASDAQ:EMCI).
EMC Insurance Group Inc’s (NASDAQ:EMCI) most recent return on equity was a substandard 5.57% relative to its industry performance of 9.42% over the past year. EMCI’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on EMCI’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of EMCI’s returns. Check out our latest analysis for EMC Insurance Group
Breaking down Return on Equity
Return on Equity (ROE) weighs EMC Insurance Group’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Property and Casualty Insurance industry may want to choose 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 EMC Insurance Group, which is 8.59%. Given a discrepancy of -3.02% between return and cost, this indicated that EMC Insurance Group 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:
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. The other component, asset turnover, illustrates how much revenue EMC Insurance Group can make from its 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. 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 EMC Insurance Group’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a sensible 4.30%, meaning EMC Insurance Group has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden and still has headroom to grow returns to industry average.
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. EMC Insurance Group exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For EMC Insurance Group, I’ve put together three key aspects you should further examine:
- 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.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for EMC Insurance Group’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of EMC Insurance Group? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!